Adobe

Adobe delivered a strong fiscal third quarter, with total revenue growing 12% in constant currency. Gross and operating margins were stable at 89% and 35%, respectively. Monthly active users across creativity and productivity solutions crossed 1 billion.

Why it matters: Despite solid quarterly results, Adobe's freemium pivot is weighing on its forward-looking metrics. Remaining performance obligations growth of 8% decelerated sharply from last quarter's 13%. Annual recurring revenue growth also slowed to 11% from 12%. The RPO and ARR growth deceleration could negatively affect Adobe's future revenue expansion. Management claims the free-to-paid conversion should materialize in 2027. However, without a clear monetization strategy, we model revenue growth to remain below 10% through fiscal 2030. We have a hard time deciphering Adobe's year-over-year AI-first ARR growth of over 150%, given the lack of clarity around the definition of "AI first." It is uncertain how newly acquired assets from Topaz Labs can narrow the gap between Firefly and frontier models for image and video generation.

The bottom line: We reduce our fair value estimate for narrow-moat Adobe to $344 per share from $380 as we bake in stronger uncertainty around the new freemium model. The shares currently look undervalued, but the freemium pivot is a risk overhang that may persistently pressure Adobe's price in the near term. Adobe's valuation is one of the lowest in our enterprise software coverage. We see multiple near-term risk factors that prevent the market from assigning a higher valuation, including increased competition from artificial intelligence labs and deteriorating sentiment in the lower-end market. In the long term, we still think Adobe's switching costs can help the company defend its status as the go-to tool for creativity and marketing professionals. Existing digital assets and workflows embedded in the Adobe ecosystem should allow stable price increases that drive top-line growth.

Adobe recently appointed Anil Chakravarthy as the new CEO to replace the outgoing Shantanu Narayen. Chakravarthy came from Adobe's customer experience orchestration unit, which targets business professionals. We interpret the move as the company focusing more on the exploration of growth opportunities among business users. Following the appointment, Adobe's president of the creativity and productivity business, David Wadhwani, left the company, adding another layer of uncertainty around the execution of its freemium transition.

Our fair value estimate is $344 per share, which implies a fiscal 2026 enterprise value/sales multiple of 5 times and an adjusted price/earnings multiple of 14 times.

We model a five-year revenue compound annual growth rate of approximately 9%. We model modestly decelerating growth in both the creative side and the customer experience side. Digital experience should benefit from price increases that filter in over the course of several years as well as upselling opportunities from new or enhanced product features. We believe a relatively frictionless cross-selling opportunity exists for the company, as creative professionals are already steeped in Adobe products. Under the freemium model, customers have more opportunities to try out Adobe’s design and publishing workflow, which should open up greenfield opportunities. On the creative and productivity side of the business, we are glad to see Adobe’s ability to draw in new users and infuse the platform with generative AI features. Additionally, the company has had success upselling existing users to higher-price products and cross-selling acquired technologies. We believe continued innovation, gathering new users, and upselling existing users in Creative Cloud should help drive strong growth for the next several years.

We model non-GAAP operating margin, which was 46% in fiscal 2025, to remain relatively flat over the next five years. Management continues to talk about pushing margins higher over time, but given that Adobe's margins are already right near the top of the software group, we think that maintaining the current margin level is already a very demanding task. We think AI growth within the mix could result in modest pressure on gross margins, which is likely to be offset by operational efficiencies, resulting in stable operating margins.

For Adobe overall, we assign a Narrow Morningstar Economic Moat Rating arising from switching costs. Given the unknowns surrounding the impact that AI will have on many software companies, we do not have a near-certainty level of confidence required for a Wide Moat Rating.

Switching costs for software are often driven by several factors. The more critical the function and the more touch points across an organization that a software vendor has, the higher the switching costs. There is also the direct time and expense of implementing a new software package for the customer while maintaining the existing platform and retraining employees on a new system. Additionally, there is operational risk of changing software vendors, including business process reengineering, loss of data during the changeover, and overall project execution. Lastly, lost productivity is likely to be an issue as customers move up a learning curve on the new system.

Adobe does not provide retention metrics because its user base has a large percentage of small-business users and periodic subscribers. Software firms regularly see lower retention rates for small-business users than for enterprise customers. Further, in the case of Adobe, many creative professionals work on a contract basis, meaning that they might subscribe to Creative Cloud for a month, not subscribe for the next month, and subscribe again the following month. We believe Adobe experiences customer retention of 85%-90%, but we also do not think this is particularly relevant for the company, given the dynamics of the customer base.

We believe the digital media segment enjoys a narrow moat based on switching costs. Digital media represents approximately 75% of revenue. This segment contains Creative Cloud, which is about 60% of total revenue, and Document Cloud, which is approximately 15% of revenue. This segment historically enjoyed a wide moat, but the rise of Figma and Canva, coupled with the rise of generative AI, has eroded that moat to narrow. Like most software solutions, once Creative Cloud or any of the individual applications contained therein is inserted into the workflow of creative professionals, it becomes difficult to change solutions. Further, while there is no shortage of competitive point solutions, Adobe Creative Cloud is so pervasive in the creative world that replacing it, especially in enterprise-scale content creation workflows, would be very difficult, in our view. Because nearly all creative professionals rely on the Creative Cloud, all other creative professionals must also use it, which hints at a network effect. While the Creative Cloud has its issues, particularly premium pricing, and any one organization or freelance professional might be willing to switch, they would find it difficult to work in an industry that has generally standardized around it.

Since its introduction in the late 1980s, Photoshop quickly became the industry leader and eventually the industry standard for image editing software. Rather than remaining complacent, Adobe has consistently invested in the solution, introducing new features and adding applications that could be sold to existing users of Photoshop. These features and products were both internally developed and from acquisitions. For these reasons, Creative Cloud still finds itself at the forefront of the industry.

We believe Adobe’s creation of the PDF file format, its first-mover advantage with Acrobat, and significant installed base have created a narrow moat based on switching costs for the firm’s Document Cloud. Within Document Cloud, Adobe created the portable document format as an evolution of its original product, PostScript. Adobe’s PDF has become the standard for document processing over the past decades, thanks in part to distributing Acrobat Reader for free to personal computer original equipment manufacturers. We believe there are no truly competitive solutions to the PDF file format, despite a wide variety of PDF editors in free and paid versions. By any measure, Acrobat remains the gold standard in PDF editors. Over the years, the firm has added a variety of key features to Acrobat, including e-signatures and the AI-powered Acrobat Studio.

In our opinion, the digital experience segment enjoys a narrow moat based on switching costs. Digital experience represents approximately 25% of revenue. This segment contains Adobe Experience Platform, Adobe Analytics, Adobe Experience Manager, Customer Journey Analytics, and Adobe Commerce. We view digital experience as a natural extension of the digital media segment and see the same switching costs that we see for most software companies. Once these applications are integrated into a business process workflow, we believe they are difficult to change. A digital experience platform is complex, involving numerous applications and touching a wide range of systems and data repositories used by the customer.

Unlike the creative side, Adobe does not have a first-mover advantage in digital experience. The company made its foray into this broad umbrella initially through acquisitions, notably of Omniture in 2009. Since then, it has made other meaningful acquisitions, such as Marketo and Magento, both in 2018, and also organically added solutions to the portfolio. Through these efforts, Adobe has established itself as a leader in digital marketing analytics, campaign management, and customer engagement, among others.

Digital experience solutions are relatively new compared with the creative side. There are various large competitors in marketing analytics, campaign management, customer engagement, advertising platforms, and related areas. While this has been a rapidly emerging area, Adobe is a leader in this space based on its holistic and robust platform, and we do not see this changing in the next few years.

Adobe software like Photoshop and Acrobat is the de facto standard in content creation and PDF file editing, categories it created and still dominates.

Adobe is able to keep up with the latest trends in the creative market. Express has helped develop a funnel of new users, while Firefly is a convenient new visual content generation tool.

Adobe can extend its empire in the creative world from content creation to marketing services by enhancing its digital experience segment. This segment should drive growth in the coming years.

The rise of cloud-native graphic design platforms that enable real-time collaboration, such as Figma and Claude Design, could weaken Adobe’s competitive position.

Digital experience is an emerging space that Adobe has yet to dominate. Growth could be slower than we anticipate, or margin expansion may not materialize.

AI-based solutions are attractive to new users with little knowledge about Adobe products. There is a fear that AI models can replace Adobe applications or pressure the company’s seat-based licensing model.