Every now and then, a great stock comes on sale in the market, but it's important to recognize whether the sale is a buying opportunity or a warning to investors.
The market may sell a stock because it's struggling, a competitor is taking market share, or for other valid reasons, but sometimes the market places much more weight on a company's short-term challenges than its long-term prospects. And that can present a big opportunity for investors.
Adobe (Nasdaq: ADBE) is one of the companies whose shares have recently fallen sharply. The company develops innovative solutions and capabilities using generative artificial intelligence (AI) to support further growth of its market-leading software suite. Despite the market boosting the stock following a strong second-quarter earnings report and improved outlook, the shares are down 24% from the all-time high they hit at the end of 2021. Investors still have an opportunity to buy the stock today.
Putting generative AI into everything
Adobe is a market leader in enterprise-level content creation software (Photoshop, Lightroom, Illustrator), document management software (Acrobat, Acrobat Sign), and marketing and advertising solutions.
Creative Cloud and Document Cloud subscriptions provide a steady, recurring revenue stream, and because the software suites are industry standards, they offer two advantages.
Because everyone else uses Adobe file formats, a network effect occurs where people in the industry need Adobe software to communicate with each other: designers send Adobe files to clients or other designers; if they don't have Adobe software, they might not be able to manipulate the design the way they intended.
The second factor is that Adobe's software is very sticky. No manager wants to risk switching software suites just to save a few dollars. It would require retraining employees and potentially reduce productivity. A freelance designer might pay a subscription fee for Adobe's software only when they need it, but they're unlikely to leave Adobe forever.
Adobe is using AI to attract more users to its products and grow annual recurring revenue. The company's generative AI, called Firefly, is trained on Adobe's own dataset and is used in popular features such as Generative Fill and Generative Expand in Photoshop, Text to Vector in Illustrator, and Remove Object in Lightroom.
Adobe offers limited use of Firefly features for free to attract new users to their products through their Adobe Express service. Firefly adoption has resulted in significant conversion to paying customers, increased revenue per user and renewals.
In April, the company introduced Acrobat AI Assistant, which can summarize documents and answer questions based on the information within them. Adobe Experience Platform now offers AEP AI Assistant, which helps marketers automate tasks, simulate results, and generate new audiences to target.
A trend back in the right direction
Management disappointed investors in its first-quarter earnings report, with the biggest warning sign being slowing average recurring revenue (ARR) growth for the Digital Media division, with new ARR projected to be just $440 million in the second quarter.
As mentioned above, Adobe's products have high retention and are attracting customers with their new AI capabilities. The company significantly beat expectations with $487 million in net new ARR in its Digital Media segment, and is forecasting strong growth going forward with $460 million in net new ARR for the next quarter and $1.95 billion for the full year.
Management commented during the Q2 earnings call that the new AI capabilities are driving higher conversion rates from free Express users, while the premium features are driving higher revenue per user and improving retention rates, which bodes well for long-term net ARR growth.
Thanks to its subscription model, Adobe generates steady free cash flow every quarter. One-time costs from the failed Figma acquisition weighed on free cash flow last quarter, but it returned to normal levels in the second quarter. The company is using that cash to fund a $25 billion share repurchase program authorized in March. The company has already repurchased $2.5 billion of its own stock in the second quarter.
It's not too late to buy Adobe stock
While you may not be able to get quite as good a price as you could earlier this month, it's not too late to buy Adobe stock.
Even after the stock price surged following its second-quarter earnings report, Adobe's stock is still trading at 25.5 times forward earnings (some of which could be revised upward given management's improving outlook), a slightly higher level than the market average for a company expected to deliver above-average earnings growth.
Adobe is a software company that is investing heavily in AI development, which should enable it to increase its operating margins as it scales and customers are willing to pay more for advanced AI capabilities. The impact of FireFly and its AI assistant should drive top-of-funnel interest in the company's software and boost conversion rates, leading to strong revenue growth. Analysts currently expect annual revenue to grow 22% on average through next year, but this number may be low given management's revised outlook.
So, it's not too late to buy Adobe stock, even after it recovers a bit.
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Adam Levy invests in Adobe. The Motley Fool invests in and recommends Adobe. The Motley Fool has a disclosure policy.
The post Artificial Intelligence (AI) Growth Stock That Dived 24% and I Just Added to My Portfolio was originally published by The Motley Fool.
