Adobe: The Figma Stigma (NASDAQ:ADBE)

Adobe (NASDAQ:ADBE) is a much discussed stock that I have a history with, having bought it and exited long before the current Figma controversy. I bought ADBE in the early stages of the 2020/2021 bull market at $450, and sold for $550, realizing a 22% gain. At the time that I bought it, interest rates were much lower than they are now, and paying 50 times earnings for high growth didn’t seem so unreasonable. However, once Adobe got to $550, I noticed that some of its valuation multiples were getting rather extreme. For example, it traded at around 20 times sales at that level (the stock price was higher back then, and sales were lower). Today, Adobe still trades at a pretty high sales multiple (10.5X), but it’s way down from where it was at the peak.

Around January of this year, I started shedding some of the more richly valued stocks from my portfolio. I knew that the Federal Reserve was planning on raising rates, and I had zero reason to believe that they were lying, so I adjusted my portfolio accordingly, selling Adobe and Microsoft (MSFT), and rolling the money into banks and energy stocks. This significantly reduced my exposure to the 2022 tech stock crash, though I kept some other tech stocks that got hit.

It’s only natural to keep following stocks you used to own after you sell them. In Adobe’s case, I kept watching the stock through the bear market, hoping to identify possible entry points. Given that interest rates rose significantly this year, I was hoping for a price far below where I bought at in 2020.

Flash forward to today. Adobe is currently buying its competitor, Figma, and the markets aren’t taking it well. The stock crashed 17% on the day the deal was announced, largely due to the high cost ADBE will incur. Adobe is valuing Figma at 100 times 2021 sales, a valuation that is practically unheard of these days. The last deals we heard of with price tags close to this were Meta’s (META) WhatsApp deal ($22 billion) and Block’s (SQ) Afterpay deal ($29 billion). Those deals, however, occurred well before this year’s rise in interest rates, making the Figma deal uniquely expensive for its time period. Additionally, the price tag is high compared to Adobe’s assets and equity. According to Seeking Alpha Quant, Adobe has $5.7 billion in cash/equivalents and $14 billion in book value. So, the deal is valued at far more than a reasonable estimate of what Adobe shareholders “own.”

At the same time, Adobe stock is not as expensive as it once was. The sales, earnings and book value multiples have all come down significantly, and the company’s recent earnings release showed strong growth. Adobe stock had already fallen so much by the time this article was written that much of the Figma deal issues had been priced in. Accordingly, I rate the stock a ‘hold’; in the ensuing paragraphs I explain why I’d upgrade it to ‘buy’ at $250.

The Figma Deal: Implied Valuation

The headline number from Adobe’s Figma announcement was the sales multiple. With $200 million in 2021 sales, Figma is being valued at 100 times last year’s sales, and 50 times estimated 2022 sales. These are rather extreme multiples. To put them into perspective: Shopify (SHOP) stock has long taken criticism for being extremely expensive, and its highest ever sales multiple was a little over 60. Sure, being able to control a company commands a premium, but a 66% premium to one of 2021’s most expensive large cap tech stocks–a tech stock that couldn’t hold it steep valuation and fell 70% this year? Seems a bit adventurous, to put it mildly.

Beyond the infamous price/sales ratio, there are other things Adobe has claimed about the Figma deal:

• The company is expected to grow sales to $400 million by the end of 2022 (100% forecast growth).

• The deal’s sales multiple will shrink to 50 if the forecast is hit.

• The company has a 90% gross margin.

• It has positive operating cash flows.

These sound like positives, but remember that these stats are hard to independently verify. The annual recurring revenue (“ARR”) figure, in particular, is an estimate. If Figma behaves like most publicly listed tech companies are behaving this year, that estimate will get cut eventually. Figma will have to continue growing at a rapid pace for Adobe to recover its investment on it, so unless the company can defy very widespread trends in the tech industry, it will be a drag on Adobe’s performance.

Adobe – Financials and Valuation

Having looked at the Figma deal itself, we can now begin to explore how it could impact Adobe’s valuation.

First the good news:

Adobe’s most recent earnings release was above average for the tech sector in the reported period. In the third quarter, Adobe delivered:

• $4.43 billion in revenue, up 13%.

• $3.8 billion in gross profit, up 12%.

• $1.48 billion in operating income, up 2.9%.

• $1.13 billion in net income, down 6.3%.

• $1.7 billion in cash from operations, up 20%.

• $3.50 in adjusted EPS, up 12.5%.

These results were pretty good for a big tech company in 2022. For comparison, Meta, Alphabet (GOOGL) and Apple (AAPL) all saw their earnings decline in their most recent reported quarters. Adobe actually delivered bottom line growth. Adobe’s growth in cash from operations and adjusted EPS both cleared the inflation rate, so Adobe increased shareholder value.

Now the bad news:

If the Figma deal doesn’t go well, then it could easily mess this whole picture up.

First, Adobe is issuing $10 billion in stock to pay for the deal, on a $140 billion market cap. So, we’re seeing dilution of 7.14%–this will make growth on a per-share basis considerably harder going forward.

Second, if the Figma deal doesn’t pay off, it could single-handedly ruin Adobe’s growth track record. After it closes, Figma will become part of Adobe’s balance sheet assets. A portion of that value will be goodwill. Goodwill is the premium over book value that gets reported on a company’s balance sheet. The company has to “test” the asset every year to make sure it’s getting economic value from it. If it turns out at a later date that the acquired company is not generating value (e.g. contributing to profits) then the goodwill portion of the asset’s value gets written down. The write down is then subtracted from net income.

We don’t know exactly how much of Figma is goodwill, but given Adobe is paying 100 times 2021 sales, and 50 times estimated 2022 sales, it’s probably a lot. According to CSI Market, the tech sector had a 0.74 total asset turnover ratio in the third quarter. If Figma is typical of its industry, and hits its $400 million revenue target by the end of this year, then it will have $540 million in assets. If that’s the case then up to $19.46 billion worth of Adobe’s purchase price could end up as goodwill. The possibility of $10 billion or more in future impairment charges can’t be discounted. If they materialize, then they’ll take a big bite out of earnings, as adobe currently earns about $4.8 billion per year.

All of this has bearing on ADBE’s valuation. Going by multiples, ADBE is a pretty expensive stock, trading at:

• 23 times adjusted earnings.

• 30 times GAAP earnings.

• 8.5 times sales.

• 19 times cash flow.

• 10 times book value.

Even after falling precipitously from its all-time high, ADBE is still pricey. However, as mentioned earlier, the company still has growth, which not all big tech stocks do these days. Apple’s revenue growth in its most recent quarter was 2%, with negative earnings growth, while Adobe was putting out 20% FCF growth. If we cut the growth rate in half, assuming that it stays at 10% for 5 years, then falls to 0% for eternity after that, while using a 6% discount rate, we get a fair value of $387. If we up the discount rate to 8%, we get a $286 fair value, which is only slight downside to today’s price. The estimates I’ve put into this model are not unreasonable: the assumed growth rate is half the historical rate, and both discount rates are well above the 10-year treasury yield.

There’s just one problem:

The sheer cost of the Figma deal. If Figma gets tested for impairment and comes up short, we could be looking at many billions of dollars shaved off of net income in one year. Net income is not the same as cash flow, but the GAAP earnings loss from impairment reflects meaningful damage to the balance sheet, dilution (shares issued), and other such things. In the meantime, the issuance of new stock will affect free cash flow on a per share basis, as it will increase the public float. That could possibly affect Adobe’s future growth rate.

Why I Have My Eye on $250

Having modelled a range of valuations for ADBE stock between $286 and $387, I need to explain why I (personally) would like to see $250 before buying it again.

It has to do with uncertainty.

Mathematically, Adobe’s fair value is near, or slightly above, the current stock price, in a DCF model that assumes modest deceleration and uses a discount rate between 6% and 8%. 4% is the current treasury yield, so the chosen discount rates incorporate some of the risk in equity investments. But in ADBE’s case, we can’t be too certain about the impact of the Figma deal. If the acquisition puts a ton of goodwill on Adobe’s balance sheet and it later gets impaired, that could cause negative earnings growth in an upcoming year. In the meantime, the new shares issued will be a drag on per-share growth. Ultimately, we’ll need to wait until Adobe starts consolidating Figma’s earnings with its own before we really know what the impact is. Possibly, my $286 to $387 range of estimates will still stand. In that case, the stock will turn out to be buyable, since most of that range is above the current stock price. Considering the uncertainty, though, I’d seek a large discount to today’s price before I’d seriously consider buying. There’s still too much about Figma that’s not yet a matter of public record.