TIVP019: Adobe (ADBE): Designing a Creative Empire w/ Shawn O’Malley & Daniel Mahncke

27:05And across those different areas, the business in total has generated over$21 billion in revenue last year with 95 % of the sales coming from subscriptions. That is, in other words, very high quality recurring revenue coming from a mix of large enterprises, independent design professionals, small businesses, and hobbyists. So not only is it very high quality and recurring, but it's also diversified. Absolutely. It sounds like the dream of every company, to be honest. And they not only have recurring revenues, we also have a recurring theme of our episodes, which is the democratization of industries.

27:44And we mostly talk about that when we mention companies like Spotify, Uber, or Airbnb, but I also tried to sneak it in in the Nike episode where I mentioned the retailers. Now for Spotify, Uber, or Airbnb, those are all companies that pushed for democratization because they were the beneficiaries of that movement. You might say that's a bit different for Adobe, but my first instinct would be that Adobe is threatened by that movement. Of course, I primarily think about AI when I say this, but even before that, there were many small companies that offered similar but cheaper services And of course, they were not as powerful, but they targeted a different customer.

28:23So as someone who has created some dozen graphics as well, although every graphic designer would take a laugh if he actually sees them, I like to use Canva for those graphics. For me, the offering was good because it was more intuitive. It was a lot cheaper. And they also have their own AI tools. If you combine all this topic, like the smaller competition and AI, how do you see that affecting Adobe five years out from now? Yeah, I'm sure we'll get into a lot more and how AI tools are impacting Adobe. But even before AI, there was definitely this trend toward professional grade design tools becoming available to hobbyist designers and individuals.

29:01So this is a trend that's bigger than the recent hype about AI. And the learning curve around design is just compressing. And graphic design is becoming more accessible to anyone. Yet, if you are a professional photographer or work at a film production company, you still need the most powerful cutting edge tools out there. And I think that doesn't include someone like yourself who's making graphics, Daniel, unfortunately, but that's where Adobe continues to dominate. Beyond that, you want a streamlined ecosystem for your workflow where you can work across different apps and basically do your entire job through a set of these connected services.

29:38And it's similar to how Apple's ecosystem is really convenient where your computer works with your watch, which works with your phone and headphones and iPad. And Adobe's ecosystem of design apps are interoperable in that same way. As I've heard it described by management, at least with Adobe, the hope is going forward, designers can go from making a 2D black and white sketch in one tool to turning that into a hyper-realistic image to then turning that into a 3D model, which can then be used to build a video. And then maybe using generative AI, you could turn that video into a metaverse type digital world.

30:13So you can go from 2D sketch to metaverse through Adobe with the point being across Adobe suite of tools, creative professionals can design creative assets throughout the entire life cycle. And to me, that seems like a compelling value proposition. Again, not only are the tools like Photoshop or After Effects individually powerful, but syncing them up and making them work across platforms more simplified has only made Adobe's offerings more attractive in recent years. Yes, you probably don't need Photoshop to make viral TikToks or Twitter graphics, but I'm sure the designers at HBO rely on Adobe tools as heavily as ever.

30:53So as design tools have become more accessible, there's been this proliferation of content creation. So there's a bigger and bigger pie and more of that content is being created in fairly sophisticated ways, but that hasn't necessarily come at Adobe's expense. Like I said, it's a bigger pie of content creation and some of it's being carved out at the low end through Canva, but I haven't seen any noticeable interruptions in Adobe's business at the top and bottom line because of it. That's an interesting part because I'm fully aware I'm on the lower end, but at the same time, I would have still thought that at the high end, so for like professional film or movie studios, they would have their own individually tailored tools, so more specialized than Adobe.

31:39But I came to find out that Adobe is actually a pretty big player in that space. And a lot of Hollywood studios use their tools as well. So that's a very interesting point because I didn't see them as being part of their main customers a couple of years ago. I kind of think of it like Google search relative to ChatGPT. ChatGPT has spurred more people to search for a wider variety of questions more frequently, but Google search remains a large and fast growing business at the same time. So rather than taking business from Google, AI has made the search pie bigger in some ways. Again, I think you could say the same has happened here with design, with Adobe.

32:16AI and Canva have enabled more people to make designs on their own, but as the barriers to design have been lowered, there's also just a lot more design and content creation occurring too. So that said, they've actually also unveiled their own set of tools meant to appeal to what you call the lower end of the market. And that is users who aren't necessarily professionals. And that is a set of tools called Adobe Express. And the idea is really a direct response to Canva. And it's meant to deliver professional design tools to everyday people, maybe small businesses, teachers, or social media creators, and give them the ability to create sophisticated graphics and videos in a simple way within the Adobe ecosystem and hope that some amount of them will eventually upgrade to some of Adobe's more sophisticated offerings.

33:06So it's a lot of pre-designed templates and drag and drop tools in Adobe Express. And as I said, it really is Adobe's response to Canva, where they left this opening in the market and Canva filled that void. And now Adobe is trying to counter that. Yeah, drag and drop tools is more my level of creative work. And by now, Well, Adobe has, and you mentioned that, grown to over, I think, over 100 tools. So an incredible amount. And you would guess that means they're now offering something for everybody who's looking. But there are still some niches where they either do not have a product, or at least there are products where Adobe's offering is just not as good as the competitor.

33:45And that's why they tried acquiring Figma back in 2022. And it was supposed to be a$20 billion deal. And since I was a Canva user, I didn't do too much with Figma. And I do know it's more powerful, but still,$20 billion just seemed like a lot to pay for Adobe. So what did you think of that deal? And, well, what has become of it? I actually never use Canva, but I have used Figma to create mockups of changes that I wanted to make to our company's website. So Figma was really helpful for someone without any programming skills, or really any design skills, for that matter, to show visually how I'd like to manipulate things and what the functionality should be like for the actual programmers who would try to implement the request.

34:31And I'm sure there are tons of other use cases for Figma beyond that, but I quickly realized just how powerful of a tool it is for web or app design. It's not hugely surprising to me that Adobe wanted to acquire them, especially if it's seen as being much better than Adobe's own user interface development tool called Adobe XD. Now, do I think that Figma was worth$20 billion after using it initially? No, I did not. But from Adobe's perspective, you could say that this just wasn't about absorbing a single competitor, but really it was going to be their response to the shift toward cloud-based collaborative design where you can work on a project in real time and others can access and see the changes you're making.

35:12Like Google Docs for designing apps and websites. That's how I think of Figma. and like I said$20 billion seems like a steep price to pay for that but it doesn't matter anyway now because the acquisition was blocked by regulators who were worried that consolidating these two companies would materially hurt the competitiveness of the design software market. The fact that they were willing to pay so much for Figma kind of shows to me just how much Adobe really missed the boat here on these freemium more collaborative design tools and Figma and Canva have largely built their businesses by filling that blind spot.

35:49By the end of 2023, it was clear that regulators across several domains weren't happy with the proposed combination and Adobe had to eat a billion dollar breakup fee that it paid to Figma for terminating the deal. So that was painful. Losing a billion dollars for basically nothing is never great, but it was a roll of the dice and evidently they thought the risk was worthwhile. They thought the deal would go through and they even stopped working on adobe xd in anticipation of joining forces with figma and once it be clear that that wouldn't happen the cost for adobe wasn't just the billion dollars it was also that they had to basically abandon adobe xd so they clearly don't think that they can even compete with figma and if they can't buy figma then they'd rather just give up on adobe xd altogether and that's very telling as to why they're willing to pay such a premium price How would you say, though, is this now impacting Adobe's Creative Cloud?

36:43Because they were willing to pay$20 billion, and you yourself used Figma. I know a lot of people who do use it, and they're even semi-professional, and now they don't even do Adobe XD. So what does this mean for their flagship product, Creative Cloud, if they do not have their own offering for that pretty big niche? There are a lot of niches in design and digital content production. And so this was just one kind of specific area where Adobe clearly lost. But their creative cloud suit of software products remains objectively the industry standard. Such that just about any album cover, movie, or even billboard graphic at one point was probably sitting in an Adobe app being edited in one way or another.

37:24Even this very podcast you're listening to gets edited through Adobe Audition. So again, the point remains that digital content in one way or another pretty much always passes through Adobe. And I had never realized that before, but I've spent dozens of hours editing these episodes in Adobe Audition. And I'm not entirely well versed on the competitors, but I suspect there's a good reason our entire company has opted to continue using Adobe for audio and video editing over the years. and I might hesitate there for a second because at first I thought one of the new tools we're using to help with leaving feedback on videos called Frame.io was some new AI-based competitor but it's actually a company Adobe owns too.

38:06So even when I think we're moving off Adobe we still remain closely tied to Adobe products without me even necessarily realizing it in some cases and in certain areas it might even be fair to refer to Adobe's positioning as being monopolistic in In some cases, like Adobe Lightroom, which is a software for photo organizing and processing, you have some professional photographers that have exclusively used Lightroom for their entire careers, 20, 30 years. And part of the way Adobe has cultivated that loyalty has been through getting people to use their services at early ages by offering Adobe software for free to teachers and students in higher education, kind of getting the next generation of creative professionals hooked on Adobe tools.

38:47Now that you mention it, I think I actually used Adobe quite a while ago. It was probably like 10 years ago because I was a student. And back then you just had a very cheap offer to use Adobe. And it's kind of a genius idea to go where people don't even have the money to pay you anyway. And then you say, okay, you can use it for free. And 10 years from now, you're used to Adobe and you just don't want to switch anymore. And I had to think about our Hershey's episode and the Nestle reference that we did, which is like every company in the food space that you don't know is owned by Nestle. And in this case, it seems that every company that you don't know is owned by Adobe.

39:25So that's just an interesting thought that I had. But we've mentioned a couple of business segments now, a lot of products that Adobe offers. So just to sort of quickly recap, can you summarize again the different business units that actually make up Adobe? As you said, we've talked in some detail about the Creative Cloud, and that makes up about 60 % of revenues. And as the name implies, it targets creative professionals with tools like Photoshop and Lightroom, as well as Firefly, which is Adobe's new generative AI tool for creating and modifying visual content. And with Firefly, at least according to the company's Investor Day presentation in March, you can do things like turn a blue sky into a sunset with just a click of a button, for example, stuff like that.

40:06Then the remaining 40 % of revenues is split between their document cloud business, which is primarily focused on manipulating pds through acrobat and then what they call the experience cloud which you could describe as this suite of apps and services that cover the distribution phase of digital content and customer profiling and through this combination of business units adobe is really a one-stop shop for the entire digital content workflow from creation of an art graphic to editing to then the distribution of that graphic and an advertisement and the performance measurement of that advertisement and then iteration where you're doing A-B testing of different versions and so on.

40:49That all from start to finish, that's all occurring in Adobe. And with their document cloud business in particular, they can basically cater to the entire enterprise's digital needs. So the document cloud business led by Acrobat does nearly$4 billion a year in revenue. And the importance of having a file format that's usable on any screen is all the more relevant given the rise of mobile devices and tablets as more people work from home. And relatedly, a significant number of all documents created in Acrobat are visual documents for things like marketing content, sales pitches, and infographics, sort of blurring the line between their document businesses, which you might have previously seen as being separate from their suite of creative tools.

41:33And now they're increasingly incorporating design tools into Acrobat, catering to more traditional corporate clients that may not actually specialize in design, but want to create graphics for presentations. And that leads to the conversation of how to think about who Adobe's customers are and how they differ depending on whether they use the document cloud, the experience cloud, the creative cloud, or maybe all three or some combination of two of those three. And across these three business units, the company is basically two buckets of customer segments that they refer to, which it breaks out as business professionals and consumers who primarily use Acrobat and maybe some limited creative tools.

42:12And then the second segment of customers are creative and marketing professionals who mostly use the Adobe Creative Cloud and perhaps the Experience Cloud for distributing content and then measuring how it performs. The last time I looked into Adobe, I came from more of a valuation perspective. which is why I was very excited when you told me that you would pitch Adobe and give a deep dive into the company. And I was surprised by all the tools that Adobe owns that I didn't even know about from Frame.io, which you just mentioned, to another one, which is called Behance. And it's like a social media or a networking platform for only creative professionals.

42:48I only know it from a friend who tried sharing his portfolio of work there to land some orders. It has even the Adobe logo. So there's IconicA on its website. So it's not a secret that Adobe owns it, but it still feels like Adobe owns a ton of companies that you don't even know about. And all that power combined just makes it an even better business. And still with the blocked Figma deal, and you said it probably doesn't matter that much, but I would argue that all this upcoming competition is still feeding into Adobe's business. How do you see the competitive landscape shifting? And how important is it that Adobe can probably not as easily acquire other companies anymore.

43:28We mentioned Figma a little bit already, and they're probably the biggest competitor, but you also have Canva. We've also mentioned a bit, but there's also Final Cut Pro and Affinity Designer and probably dozens of other smaller and more specialized services in the creative world that I'll be the first to admit, I'm not familiar with. I'm not a creative professional. I'm an investor. What I do know is that none of them have the product ecosystem and ability to bundle services together like Adobe, at least among those design-focused companies. I will say in different ways, Adobe also competes with companies like Microsoft, Oracle, Salesforce, and even Google through its experience cloud that caters to marketing analytics as well as in document management.

44:08But still, having interoperability between two dozen different programs that can all work together seamlessly is a real competitive advantage at the enterprise level, particularly for creative professionals. And Microsoft and Google, at least in the design world, cannot match that. And after all, design is the largest part of Adobe's businesses. I don't think it's just the creative cloud business that's really sticky though. With the experience cloud, in some cases, it can take companies several years to get completely onboarded with using Adobe's experience cloud offerings. And as such, it would be almost unimaginable to try and suddenly pivot toward something else.

44:43So the extent to which Adobe's offerings are ingrained into just corporate routines and infrastructure can make some of those earnings very durable, even if they don't always have as clear of a competitive advantage in the non-design services that they offer. So even if switching costs and barriers to entry have fallen in creative tools, as long as it makes sense for corporate customers to bundle creative tools with the experience and documents cloud, I do think they're likely to continue relying on Adobe for both simply because of inertia, but also maybe just because it's simpler. It just simplifies everything for them.

45:16And if you take a look at the numbers, it just seems like Adobe is growing and growing. In the last five years, the return on invested capital has been north of 22%. At least that's what Finchard is telling me. The revenues are still up 11 % year over year. So there's no sign of slower growth or kind of competition feeding into Adobe's business. They even introduced some new metrics in the last earnings report to deliver some more insight and tell investors, hey, our business is doing good. One of them is the subscription revenue for business professionals and consumers, which is a bit weird. They define it as revenue from the document cloud, then Acrobat and Adobe Express.

45:56And those grew 15 % in the last quarter, and they represent about 28 % of the total subscription revenue. That's interesting because those are the exact same customers that we are talking about if we talk about the threat of AI. So those are the customers that are probably the least ingrained in Adobe's ecosystem that wouldn't have to face these high switching costs that the enterprise customers would face. And they have also metrics for the enterprise customers, which are defined as all the revenue from the digital experience. And most importantly, the creative cloud minus Acrobat, which is going into the semi-professional businessman.

46:33And then they grew about 10 % in the last quarter, and that's a lot more revenue. It's about 72%. But it still just shows you that Adobe's business is stable and growing, and especially the part of the business where people seem to fear that AI is actually taking market share. Definitely true. And maybe competition could limit some of Adobe's ability to raise prices for certain products. But at the same time, as we've talked about a little bit, Adobe has so much room to not only expand its offerings and bundled services together that it just doesn't necessarily need to raise prices to increase its average revenue per user.

47:11It can instead just focus on getting existing users to use more and more Adobe programs, cross-selling existing users rather than pursuing new ones or relying on higher prices. And on that point, Adobe has more than 22 ,000 enterprise customers and just 1 ,500 of them pay for five or more Adobe services. So there is seemingly a lot more room for continued cross-selling that can get existing customers using more Adobe offerings and just raise the business's ARPU. But at a high level, my impression is that Adobe's position remains pretty solid. And we might just consider Excel as an illustration of why, because I think both of us coming from the financial world are very familiar with Excel, so we can understand it.

47:50Excel is the industry standard for much of the work that gets done in the financial world. if someone designs a superior spreadsheet product with AI. The vast majority of customers will just wait a few months for Microsoft to incorporate those products into their platform. Rather than jumping ship and converting every file they've ever made in Excel over the last decade to some new spreadsheet tool on a whim, right? We're just not that sensitive. I've heard about probably better spreadsheet products, and I know for at least you and I, we're still in Excel. Companies and individuals who have used Excel for two decades aren't going to jump ship that quickly from it because a new product is maybe 20 % better.

48:28Something would have to be 10 times better to really drive massive churn in that way. And I really believe it's a similar dynamic, if not even more so in the design world. You could compare Adobe to maybe the broader Microsoft Office suite. So not just for the creative cloud, but also for the documents business. Adobe has benefited from this considerable first mover advantage with Acrobat to an extent that there are essentially no legitimate alternatives to the PDF file format. It doesn't exist. And by any measure, Acrobat remains the gold standard of PDF editors too, which is of course natural because they are the ones who created PDFs.

49:06So it's just very difficult to imagine companies at scale abandoning Adobe's enterprise tools for editing PDFs with Acrobat, especially if they're bundled together with these other products and services that Adobe offers. And quite literally, in the course of researching this episode, I don't know about you, but I probably downloaded at least five or six PDFs. And just to clarify, because I think it could still be unclear, PDFs are free to download. But if you want to edit them, add signatures, make annotations, do password protected documents, or even use Adobe's AI assistant to summarize and actually ask questions about documents and have the AI chatbot answer things about them, or otherwise just manipulate PDFs as part of your workflow, then you're going to want to pay for a service like Acrobat Pro.

49:52And I keep comparing Adobe to these other big tech companies to make my points. And to continue with that, what I'm describing here is similar to how anyone can use Google Docs. But at the enterprise level, to streamline things for an entire company or team or just to unlock more advanced tools and storage, you have to pay up. So there's a funnel where at the top, you try to have as many people as possible using your products, which Adobe has succeeded in the PDF world. And it's a different story with their design tools. And that is what Canva and Figma have filled a void in. But then there's a smaller set of users ultimately in that funnel who pay for more advanced options that end up supporting the entire business and actually subsidizing the free versions of what they're able to offer.

50:34And that's true for Alphabet with Google Docs. It's also true with Adobe here? I feel like we've talked about AI already 10 times, but we've only really dug deep into the competition arising from Canva and Figma. And we only talked about the short-term risks of AI and how they generally shape the industry. But how do you think about it more long-term? So whenever I see a photo or video that other people, assumingly, create with AI, I think, okay, that's it. If we can do that just using AI, we don't need Adobe anymore. And then I tried to do it by myself and the results are, they are mediocre at best.

51:10And probably I'm the problem. But still, today's tools cannot yet compete with what Adobe can do. And that's what you pointed out as well. You have this huge mode where even if they could, people would probably wait for Adobe to have something which is only 80 % as good. That's fine for them. But how do you see it more long term? In like seven to eight years? I don't think it's a problem in two years. But do you see tools, AI tools, or maybe Canva leveraging AI tools to create their own ecosystem, which is almost as good as Adobe's in maybe six or seven years, which would be a problem because Adobe is probably an investment that you would like to own for the long term, right?

51:51Yes, I would. And I guess I say it as kind of a joke, but I think there are a lot of people who just dislike the fact that Adobe has been at the top for so long and that their products are so hard to avoid using, which is great from an investor's perspective. But yeah, there's definitely a cohort of people who want to celebrate what they hope is the end of Adobe's dominance. And from what I can tell, at least that's just wishful thinking. It's entirely speculative. And we all see these image creation tools from companies like OpenAI, and they've gone viral, and it's really easy to think, okay, it's over for Adobe.

52:25But there is a big difference between more people being able to create art and even short films with broad AI tools. And it's another thing entirely to displace the tools that professionals use on a daily basis, which also sort of implies that people think Adobe doesn't have its own generative AI tools. And that is just not true. I'd argue that Adobe is considerably better positioned to monetize generative AI and creative work, not just create viral tools that people like to play around with, but actually commercially viable AI design tools. And that's because they can directly integrate AI tools into the software that creative professionals already use.

53:03They have this platform advantage that these other applications don't. So for example, you can create and edit images with chat GBT, but there's two problems to doing that. The process is not efficient because it might require many prompts. And the end result is unlikely to look exactly like the one I would have imagined. And you can imagine that for professional designers creating designs for brands who probably have very exacting standards about even the shading of colors used in an ad, that is a problem. You can't just rely on ChatGPT to make a company's brand art come to life. You can ask ChatGPT to make a Coke ad, and it may do a pretty decent job.

53:44But again, there's a serious lack of precision because ChatGPT is ultimately a very generalized tool. And Adobe's management team actually argues that AI will lead to more content being generated, which will ultimately need more editing, which will actually lead to its products being used more as creators seek more precise tools. So you'd almost think of AI as like a gateway drug to getting more people eventually hooked on Adobe. And companies like Coke and Toys R Us have famously used AI to make some ads. There's this Coke ad that played in the Super Bowl a few times, and there was a whole lot of hoopla about it.

54:19But when that happened, Adobe's Firefly AI product wasn't out yet. So I don't want to pretend like companies aren't using AI at all, but we've seen very few instances of it. and those instances happened before Adobe's response had come out yet. I've also seen some of the Coke AI ads and I know they're getting a lot of backlash about being clearly AI but honestly, I don't get the fuss around it. I think it's a bit different culturally because the Super Bowl ads have such a high status and that's why people just want to enjoy them. But in the end, to me, it's just an ad so I don't like to watch ads anyway.

54:54When I see the Super Bowl ad, I just ask myself, what does this has to do with code, for example? Why are they doubling down on this AI trend? And I think that the backlash emphasizes that people prefer to see human interaction and things that are supposed to touch humans emotionally. That's the goal of every creative work. So perhaps it's also more of a short-term hype that you want to create those images and all of that with AI. But in the end, it turns out that people want it to be more human. The argument for why AI isn't as much of a risk as you might think, is that AI models have a good chance of being commoditized.

55:31And in some ways, they already have. In that case, Adobe will increasingly integrate third-party AI tech into its apps. And as a company with the largest distribution of creative products and decades of relationships with major companies who rely on its services and just an air of legitimacy that some of these other companies don't have, I think it can still win. And it's actually playing from a position of strength, assuming AI models become increasingly accessible. And from the perspective of large corporate customers, I'm sure they'd much rather have an all-in-one partner like Adobe than dozens of different one-off AI tools being used throughout the company, even if each individually standalone tool is maybe marginally better than what Adobe has.

56:12And rather than being concerned that AI is going to disrupt Adobe's business, I think the concern from the market laying down its stock, maybe more that Adobe is going to have to invest in AI, yet these new AI tools won't necessarily increase their pricing power at all. They'll be making these big investments just to maintain their current market and earnings power, but not necessarily to increase them. Still, the casual designer might use standalone AI products, but major corporate customers are likely to want more robust end-to-end solutions. And if the lone freelancer or small firm switches away from Adobe's creative cloud, they'll find themselves working in an industry that otherwise entirely runs on Adobe still and is still standardized around it.

56:52I mean, they would probably ultimately just be complicating their workflow by trying to move off Adobe. It's like working in finance and trying to use Google Sheets when everybody else is using Excel. And on that point, Photoshop has been the industry standard for 40 years. And at any time, you could have probably convinced yourself that some new competitor or technology would upend Adobe's leadership. I don't want to sound like somebody who doesn't understand the innovator's dilemma and how companies can be disrupted because that does happen. But I mean, in reality here, we're talking about a very long runway of dominance and they've only continued to invest in making the service more powerful and just compounding their advantages.

57:32Further entrenching Photoshop's position, for example, as the industry choice for image editing software. And I think people who warn of AI disruption to some extent are probably casual designers or people who have never purchased an Adobe product. And they're probably not necessarily reflective of, first of all, demand from enterprises, but even really Adobe's target customers. Adobe's enterprise products have only continued to grow. And so the picture is better for Adobe around its high-end services. I'll be the first to say it. But certainly at the lower end of the market, there is some room for disruption and some serious competition for casual design products that we've seen.

58:07Fortunately, the enterprise segment is a significantly larger chunk of Adobe sales than any sales they get from these individual casual designers. And the enterprise segment is not only the most important for Adobe, it's also where there's a certain problem discussed a lot, and that is the widespread use of AI and the protection of intellectual property. So just as with all the other forms of information that AI tools, for example, ChatGPT, use to either train their models and then give you answers, there's a pretty big debate about the right of publishers and if they're actually being treated fairly.

58:40And in your Reddit episode, you mentioned a deal between Reddit, which was signed with, I think it was ChatGPT, to license their content to AI tools so that they get a bit of the profit from what would probably happen anyway and has happened in the past before. So OpenAI didn't have corporate customers. So for them, it doesn't really matter if there's a big legal framework or if there might be a copyright infringement. But for Adobe, that's very important because of all their enterprise customers. And it can get very expensive if they are getting sued for copyright infringement. With all those AI tools, and you mentioned that Adobe also has a lot of them integrated into their services by now, how have they navigated this concern?

59:23And is there maybe even a competitive advantage that they have and can use? The really interesting thing that they've done that I think is a testament to management's foresight has been to build their AI tools in a way such that they're completely legal. And to me, this is one of the most compelling parts of the Adobe thesis and why AI is arguably an opportunity for them. There are no gray areas with property rights here with their products. They've paid to license all the data that their models are trained on. And as such, they can promise to content creators that they can use Adobe's generative AI tools without any fears of infringing on others' work.

59:57And that is, as you touched on, the big concern with generative AI, right? professionals can't really take the technology seriously because there's a risk that if they use it, they can get in trouble for plagiarism or copyright infringement. All of that is still being sorted out. But Adobe also doesn't train its models on users' creations either. So this really epitomizes the difference between casual creators who just want cheap AI tools to generate images for them and the more serious enterprise customers that Adobe caters to who want to ensure that they're not creating any legal liabilities for themselves by using AI and also that their own work isn't being used to train AI models that will benefit their competitors.

1:00:35Adobe being able to offer 100 % commercially safe AI tools just strikes me as a huge value add and a really serious distinguishing factor between them and these smaller competitors. We've pointed out about a dozen times now that the both of us are not professionals when it comes to graphic design. But one of my favorite research methods is what you can call the scuttlebutt approach that's originally introduced by the famous investor Phil Fisher. And nowadays it's pretty famous. I think Buffett talked about it, Munger talked about it, and it's used by a lot of investors. And the idea basically is to gain insights into a company by questioning customers, employees, and just about everyone associated with a company.

1:01:19Now, as I said, the both of us, we're probably not the best people to ask because we're not creative professionals. But here at the Investors Podcast, we do have actual creative professionals. So did you take that chance and use the scuttlebutt approach by getting their view on Adobe and its products? We're very fortunate. I have a full support team of creative professionals who do our audio and video editing, update our website, design graphics and logos for us and all that kind of stuff. So it's only natural to talk to them about how they perceive Adobe and how they use it so we can better understand it.

1:01:52So that is, of course, anecdotal evidence, but I do think it is helpful in forming a well-rounded opinion on Adobe. And so I asked them all the same set of questions. Questions like, in terms of how you've used Adobe and your understanding of how others you've worked with feel about Adobe products, would you say they're the gold standard for most creative work? Or do you think generative AI and other AI-based tools make Adobe less worthwhile to pay for? And one of our colleagues here at the Investors Podcast Network told me, quote, in the creative field, there is an expectation that professionals are proficient in Adobe programs.

1:02:26Throughout my entire career, Adobe has been the primary tool I've used. And during my college courses, we primarily trained in Adobe software. It's deeply ingrained in the industry. She's also said it would take a lot of getting used to for a company to switch away from Adobe and that Adobe's bundling of tools helps to justify the expense typically. And in her experience, she told me that she still believes it's worth paying for Adobe as there's a certain convenience in not having to visit another site or use different tools since Adobe has everything built in. And most of her use of AI through Adobe has been with Photoshop's generative expand tool, which is apparently incredibly useful.

1:03:04And the way it works, as she explained it to me, is that if an image is cropped, the AI can generate additional background or extend a portrait from a headshot to a full torso. And you can also ask AI to generate objects, such as maybe replacing a tree with a lamppost. And just the feedback I got from her and some of our other colleagues was in that same vein. reiterating how Adobe is so essential and how it's the industry standard, how hard it would be to imagine switching from it, how competitors like Canva are nice, basic alternatives, but also not serious competitors and how powerful these new AI features are.

1:03:39And when you overlay that kind of real world feedback with the financial results for Adobe, to me, it paints a very exciting picture for investing in a company, especially at relatively beaten down prices with, I mean, And shares are down well over 20 % in the last year. I think you mentioned already the two most essential advantages for Adobe regarding AI. The first is that customers can be sure about the legal use of Adobe's AI creations. The second is that their ecosystem is so powerful that customers will wait for Adobe to adopt anything new instead of just initially switching and all the costs that are involved in that.

1:04:14One thing that I would also add is the more personal thing. So it's a bit subjective and perhaps some people disagree. but we've talked about it with the coke ad for me there's just something personal about a human touch and all of those creative things and studies have shown that most people don't want ai pictures or ai videos or even worse ai music i think we've seen something similar with nfts just a couple of years ago where all of the new art had to be an nft and honestly i don't think anybody really liked it it's just that art and creativity are deeply human and the willingness to pay also seems to be higher for creative products which are made by humans rather than AI.

1:04:50At least in the long run there's always the option for a short hype but in the long run I think that's what people would actually want. Having said that when I look at Adobe's stock chart I see a company that is flat over a five-year period now so investors are definitely worried about something and the AI topic is now widely discussed and it's also known so if we would have to look for other arguments that Adobe bears come up with what are the main ones and what do you think about them? Well, beyond the whole AI thing and how that could lead to a paradigm shift in content creation or force Adobe to spend just a ton of money on these AI-based tools that might not necessarily increase its pricing power or the number of services it can sell, you could argue that momentum is maybe slowing in the creative cloud business after a few years of elevated growth following the transition to a subscription model.

1:05:38So there is that kind of slowdown that's maybe starting to priced in. So Adobe's most dominant business unit is going to see growth continue to slow, or at least that's what a bear would tell you. And then the digital experience segment, this is an area that Adobe isn't nearly as dominant and faces some tough competition from these other big tech companies who have their own data analytic offerings that they can bundle with other services. And just to paint some more color on the digital experience segment, this has primarily been built out through large acquisitions, like the deals that Adobe made to buy Magento and Marketo in 2018 at a combined price of$6.5 billion.

1:06:14But it's hard not to overpay when making these massive acquisitions and even harder to fully integrate two different companies into your own business. And you could argue that Adobe has shown that, especially outside its core creative cloud business, it needs to grow by buying competitors. And that's just an expensive and potentially unsustainable game for trying to improve your business or expand market share in economical ways. If they were to struggle to integrate these companies or other acquisitions as hoped or realize they overpaid for them, then they'd have to make write downs that could materially hurt earnings for years to come.

1:06:47So the Experience Cloud is in some ways the weak link at Adobe in terms of competitive moats. With the document business and Creative Cloud, I think Adobe's moats are probably as wide as any business out there, but its advantages and digital experiences are just much narrower. I do think Adobe has had and does still have some powerful moats from network effects to first mover advantages, economies of scale, brand awareness, and other factors working in its favor. But those moats don't guarantee success either. Moats can road away either slowly or quickly in some cases. And I can't argue in good conscience that there isn't a high degree of uncertainty around Adobe's business going forward.

1:07:26I do think its moats will protect them from a lot of pain in the short term, but over five or 10 years, there is no guarantee that the business will significantly grow or won't become much less profitable. And that's the risk we take as stock investors. And those downside fears are obviously what the bears are very tuned into with Adobe here. But you mentioned it. I mean, that uncertainty is part of every investment decision. We would all like to have this safe and sound investment where there's no uncertainty involved. But if you have those companies, you pay the price for it. And with Adobe, you have what's arguably a pretty cheap valuation.

1:07:59and that comes with some uncertainty and perhaps some risks. And I think we've already done a pretty good job at showing if the data is actually supporting the fear that the market has, or if it seems to be a bit overblown. And that's why we have to think in probabilities and from a perspective of risk and reward and how this will actually look for Adobe is something that you will tell us later on in the evaluation section. But perhaps there's some more threats that you want to talk about before we get to that. If so, that's the time to do it now. One of the clearest threats to Adobe, we should maybe pull the thread on further, is the proliferation of this low cost and free design platforms that cater to non-professionals and casual creators.

1:08:42I know I've maybe felt dismissive of it throughout this episode, but it is worth understanding better. Obviously, I'm looking at Canva in particular here, which is an online design tool that provides templates for social media graphics, presentations, posters, and has that really easy drag and drop interface that we've mentioned. And Canva's growth has honestly been explosive. As of 2023, it reported 180 million users worldwide with over 16 million paying subscribers. And that demonstrates huge demand amongst users who value simplicity and low cost above everything else. The risk for Adobe is that a whole generation of individuals and small businesses may never enter the Adobe ecosystem and instead find that Canva is just good enough for their needs.

1:09:29Canva uses a freemium model and that undercuts Adobe's pricing for those who don't require the full power of Adobe's Creative Cloud. It's just too much. The bundling is great for enterprises, but the individual and small business level, it's just too much that people don't want to pay for. And just to look at the bare case a bit more here, they would argue that as AI design tools mature, businesses and individuals might just rely less and less on these professional software and may not even ever have the skills to use professional software like Photoshop. So instead of hiring a Photoshop expert to create a marketing image, a small business owner might just simply describe what they need to an AI and get a pretty usable result that is good enough.

1:10:09And that democratization threatens Adobe by potentially reducing demand for high-end tools among certain customer segments. We haven't seen it yet, but you could imagine that this is a real wedge in the flywheel that has been spinning for Adobe for a number of years now. And maybe to put it differently, if good enough AI generated content becomes widely acceptable, the need for an expensive creative cloud subscription could diminish. But that's all a lot of ifs, if we're being honest. And if we talk about Adobe's demise, that has been ongoing for years. But when I look at the numbers today, Adobe has compounded its revenue by nearly 14 % a year since 2019 and 16 % a year for net income.

1:10:50So there's been no issue with growing the business up until now. And then with more than a 30 % net income margin and a secure balance sheet, which I think has about$900 million in net cash, the company is very profitable and also financially sound. So it's hard to argue that there are any of these cracks visible in the business yet. And even when you account for stock-based compensation, Adobe's free cash flow margins are also well north of 30%. So now balancing the potential risks with these still very healthy fundamentals, what did you make of it valuation-wise? You captured the picture pretty well there.

1:11:26And given the quality and resilience of Adobe's business, it has been surprising to see the extent to which the market has soured on the company. The numbers for Adobe are as good as any Mag7 business, but for whatever reason, they're not lumped into that same category. The only thorny thing in their financials is the stock-based compensation, as you called out, which is significant, but also has a percentage of free cash flow. Adobe's stock-based comp is about 10 percentage points lower than Alphabet's, which notoriously has pretty high stock-based comp. So Adobe's is high, but not crazy relative to other big tech companies.

1:12:04It's about 20 % of free cash flow, and I would prefer that it was zero, but that is not realistic in this industry. So just roughly thinking about the valuation, I wanted to look at the free cash flow yield, which is like the concept of a dividend yield or earnings yield, except just with free cash flow instead of earnings or dividends. And basically, you're just taking the inverse of the price to free cash flow per share ratio. If a company trades at a price to free cash flow of 20, then you take the inverse and divide one by 20 to get a 5 % free cash flow yield. And the point being, the higher the yield, the better, because it means you're getting more free cash flow per share when you purchase the stock.

1:12:41And with Adobe, as we mentioned, we want to make sure we adjust that calculation of free cash flow to account for the effects of stock-based compensation to kind of get a clear picture of the economic reality here and the company's true valuation. And after doing that, Adobe's adjusted free cash flow yield is roughly four and a half percent, which is not bad at all. Alphabet's adjusted free cash flow yield, and I did go through and calculate it for these different big tech companies. For context, Alphabet's is a little more than half that, and Microsoft's is a little less than half that of Adobe's.

1:13:12So compared to both of them, despite having a similar set of industry-leading software services, a diversified business model, very high margins, a strong balance sheet, and recurrent revenues, Adobe's stock is valued considerably more cheaply than these peer companies like Microsoft and Alphabet, at least in free cash flow yield terms. Something that I like to do is, And I know that's a rough estimate. It's like a rule of thumb, but it is to determine the expected total shareholder return by adding up the current free cash flow yield with the expected annual growth in free cash flow over, let's say, the next five years.

1:13:47So with Adobe, for example, you would take the 4.5 % free cash flow year that you currently have, and then you would add the 8 % to 10 % free cash flow growth per year, which wouldn't be unprecedented at all for them. And then assuming that most of that free cash flow is going to share with purchases, which is also common for Adobe, then you get a low to mid double digit expected total shareholder return. That's without super aggressive assumptions. It's pretty much in line with what management is telling you. and perhaps even slightly below that. And that's back of the envelope math, and it's pretty rough, but I guess you know where I'm coming from here.

1:14:24Yeah, exactly. And to your point, Adobe has historically put three quarters of its free cash flows towards share repurchases, and even more so in recent years. And Adobe's management has said they expect double-digit growth annually in free cash flow going forward. So your rule of thumb here actually ends up working out pretty decently as a way to tell us that as long as Adobe can keep growing as expected, without any wildly optimistic assumptions. And at least based on the current valuation, it is not a stretch at all to think that this company can deliver double-digit annual returns, which is my benchmark for an investment.

1:14:58And if I can plausibly expect as my base case a 12 to 15 % annual return, I can still earn a satisfactory return in a bear case and much, much more in a really optimistic bull case on top of the moats and qualitative advantages around Adobe's business. then man, that just starts to look like a really attractive risk return profile with Adobe. And on that point, the company is trading at its cheapest price to free cash flow multiple of the last decade, around the same levels as 2022, actually a bit below that now, during that time when tech stocks across the board were getting hammered. And there are also some signs from the company itself that they see the stock as being attractive too, given that the company has not only accelerated the timeline for its share buyback program to purchase more shares sooner.

1:15:42But at the same time, insiders like the company's CFO, Dan Dern, have been making sizable open market purchases of the stock, which is almost always a good sign, right? The CFO in theory should know better than anyone what Adobe's intrinsic value is. And if he's buying that, that gives me some reason for optimism. And just for reference, I like to read Morningstar Research Reports and their equity research plays a fair value target of $590 per share on Adobe. And just for context, at the time of recording, adobe's price is about 350 dollars per share and so they obviously see the companies being considerably undervalued i'm not as bullish as them but i get how they get to those numbers and in part that's based on the assumption that as management has said the company can continue to compound earnings at double digit rates while r &d costs normalize in the coming years after rising recently to develop ai tools there's another way to say you're going to have top line growth and you're going to have accelerated bottom line growth as margins further improve for Adobe.

1:16:40Morningstar is a great source, but I think they also have a price target for Nike of over $100. And we've seen that there's a debate about what Nike is actually worth and we debated for sure on that. So how does Morningstar's target and the rough math that we did around free cash for yields corresponds with the price target that you got for Adobe using your own intrinsic value model? I'll try not to bore people with the details of my model too much, but I always find these basic models as being helpful for thinking about the thesis. So for example, I just made basic estimates for how quickly I think Adobe can grow its three core businesses based largely on really just looking at their historical growth.

1:17:19And then I looked at things like how much of operating profit typically converts to free cashflow, net reductions and share counts from stock repurchases over time, trends and operating margins and all that stuff. And I get kind of a rough estimate of what I think Adobe's free cashflow per share can look like by 2029 in a base case. And from there, like I usually do, I try to use a range of exit multiples where I use these weighted values and then some kind of discount rate to get a ballpark number for the company's fair value. And then I tack on a 20 % margin of safety to arrive at a price target of $390 per share as my base case.

1:17:55And if the company can converge on my estimate of fair value from that intrinsic value by price target, that would imply a return of 12 % to 13 % per year. And actually, from the current stock price, which is below my intrinsic value by price target, the expected return is actually closer to 15 % a year. And to me, that's very solid, given the wide moat I believe Adobe has around its core business and its prospects for growth by upselling AI tools and dundling services together. And so if we can roughly get Adobe at anything below$3.95 per share, which it looks like we're going to have a chance to get a significant discount to that, then I would really like to add it to our intrinsic value portfolio and maybe at like a 5 % to 7 % weighting.

1:18:40As always, you can access our models and download them to use for yourself. And to do that, just make sure you subscribe to our intrinsic value newsletter. And we have the link to that in the show notes below. But that's just my thinking. Like I said, I'm underwriting a 15 % annual return. I'm talking about 5 % plus position sizes in Adobe. I've already personally invested in the company, so I'm bullish, but also biased. How do you see it, Daniel? Is Adobe a company, after everything we've talked about today, and after some of the research you've done previously, are they a name that you want to add to our portfolio?

1:19:12And if so, are you comfortable adding them in the same weight that I've proposed here? Well, that's the thing, right? I mean, I've researched it prior as well, So I don't know if I'm totally unbiased here, but I always said, if you can get this company below$400, it's probably a great deal. And now we're way below$400. And I actually didn't start investing afterwards. I don't even know why. I just didn't get back to the company. But now you've made this great deep dive. I look at the numbers and you know that I always have a bias for strong brands and businesses with modes who are selling at what we are thinking is a discount.

1:19:43And I think the mode of Adobe is pretty big. I think that, as you said, they have their own AI tools. So I don't see why there should be competition that is taking all that market share away from them. I don't personally see that. And at the prices it's currently selling, I'm kind of asking myself if we miss anything. Because if you're on the market, you always have to second guess your own opinion, especially if it's a lot different from the market. The market definitely expects Adobe to get disrupted in some way or the other. Maybe it's AI, maybe it's other competition, but they are expecting Adobe's business model to deteriorate significantly.

1:20:18and you and me, we are thinking that fear is overblown. And we like to point, or what I often do is I point to Meta in 2022, where a lot of people said that business model is basically gone. And I know there's a lot of survivorship bias whenever you mention Meta because it's a fantastic company, but it's also one out of a thousand and 999 have probably gone bankrupt after that. Personally, I don't think Adobe is one of them. So at that price, I'm willing to have a position sizing of 5 % to 7 % because I think it's a great investment. I like the way you said I think I think the meta example is a great one it was exactly where my head was going to because just as the big tech company with the platform and the reach and everything we've talked about today with Adobe of course they're much more similar to meta than many other businesses that have you know had an advantage and then lost it and I mean if we can flash back to 2022 if people remember the narratives around meta at that time they seem absurd now but people were saying Gen Z doesn't use Facebook.

1:21:15Facebook's not cool anymore. Instagram is getting its lunch eaten by TikTok. Apple has changed privacy rules that are going to ripple through and kill advertising on Facebook. And there was a fear that there was a recession coming that never manifested then. There's all of these factors that were combining together. And I mean, at one point, at least from its peak, from trough to peak, I think Meta has been a six bagger. And typically we have to recognize that a lot of things are priced in the market and that the market is typically pretty good at factoring in information. And so you really do have to think through seriously, okay, what am I understanding that is not being appreciated by the market?

1:21:51And what is the reason for it not being appreciated? And so it's really easy to either buy in completely to the efficient markets hypothesis or dismiss it. And in this case, this is just a great example of Meta as a multi hundred billion trillion dollar plus company should be as efficient as any out there. And if Meta can be a six-bagger as recently as from 2022, that just is a great example to me of what Warren Buffett talks about all the time with Mr. Market and how Mr. Market is not rational. And I think we saw that as we've talked about with Meta. There's a great example of how the market freaked out.

1:22:28It was wrong and Meta ended up being a great business to continue to own. And a lot of all that stuff was just fluff and narrative. in my gut feeling is that a similar thing is happening with Adobe right now. That is not to promise Adobe will be a six bagger. I mean, there are real risks here. There are a lot of companies that have succumbed to the innovators dilemma. But if I had to bet, which is kind of what we're doing when we're talking about a 5 % portfolio size, I want to think about Adobe as a long-term owner of the business. And as such, I think that they can weather this kind of current narrative storm where everyone has soured on Adobe.

1:23:01I'm guessing in 12 to 18 months, the market will have a very different view of the company. And what gives me hope that we're not too far off with our assessment of Adobe is that there are clearly irrational reactions to Adobe's, for example, last earnings report. A couple of weeks ago, we talked about Nike and you just mentioned how Meta was supposed to lose its coolness. Gen Z doesn't use it anymore. Those are the exact same narratives that we talked about with Nike. But there's one important difference because Nike's earnings, Nike's fundamentals, they actually deteriorate. So you need a turnaround.

1:23:34In this case, and also in Meta's case, you have a company that doesn't show any cracks. There is no big backlash. There is nothing that could indicate that the company is actually being in demise. So what we have is a growing company where you just think, okay, there might be something happening out five or six years, but it's not actually showing in the numbers. And when I talk about irrational behavior, the last earnings report that Adobe put out, They beat the revenue estimates. They beat EPS estimates. They even kept their full year guidance. And the stock sold off 14%. I just don't think that's rational in any way.

1:24:08And if I see something like that, I feel reinforced in my assessment to say, perhaps the market is not as efficient in this stock as it might be in others. I agree. And actually, I use the tariff day mark. It was like a three day period where the stock market just was collapsed. or you had the S &P was down like 12 % or something ridiculous in a single day. And of course, that's a time that causes dislocation. So I use it as a chance to personally build my position in Adobe. And I invested a considerable amount of my portfolio, a couple percent into Adobe, because I said, what do tariffs have to do with Adobe?

1:24:44I mean, of course, they would feel an economic slowdown, but it's like, this is a software company, a global software company. So tariffs have quite literally nothing to do with Adobe. And I'm sure you could draw a map of different ways it'll affect them. And I'm not going to say that they wouldn't be hurt by it, but I think at the same time, we can both agree like, hey, if Adobe is falling 10 or 15 % in a day on a tariff induced market panic, this is probably not reflective of real changes in the business. And I think as investors, we can be really paranoid about always thinking about the future, right?

1:25:14Of course, when you buy an equity, it's all forward facing. You get the returns of how the business is going to do in the future, not how it's done previously. So we don't want to spend too much time on the history, but at the same time, we have to put our paranoia at ease a little bit and say, okay, Canva and Figma and chat GBT have been around for years now. And where is the evidence in the financials that is damaging Adobe? Not to say that, you know, Adobe couldn't have otherwise grown a bit faster, which I'm sure is true, but damaging them. It's not like Nike. And I know Nike is a position we hold, but I think we'd also both agree because it's our smallest position.

1:25:49It's not something we have our highest conviction in because we have seen the moats deteriorate and we have seen the business actually be affected. And with Adobe, there's just so much fear around how the business will be affected and we just haven't seen it in the results. So I feel good. We'll talk about it more in the newsletter when we make our official update on how to weight the company in the portfolio. But right now we're thinking of probably at least a 5 % position. So I think that's all I have on Adobe, Daniel. Maybe with that, why don't you give us your teaser for next week's pitch?

1:26:23The first thing I can say is that I can assure you next week's pitch won't force you to listen to another attempt to find value in a challenging industry like some of the last pitches. It will actually be a high quality company with a ton of competitive advantages and perhaps even more than Adobe. And I don't think it's too hard to guess the company, which is where I won't give you three here this time. Let me just say that it is a company that makes money when you spend it. And I know that's an obvious one, but it does so without you buying stuff from it or actually really being its customer.

1:26:57I think a lot of people actually have a hint now, will actually know now what company I'm talking about, but perhaps that's probably all I'm saying. Okay, all right. I look forward to it, Daniel. For today's quote that we always like to end every episode on, I wanted to pull from the original king of creativity and design, Walt Disney. And he says, you can dream, create, design, and build the most wonderful place in the world, but it requires people to make the dream a reality. For Adobe, it is their customers who use Adobe tools who make the world a little more wonderful. So that's a nice little thought there to wrap things up with Adobe.

1:27:36And we will see you again here next week.

1:27:44Thank you.