Head of Equity Strategy
Summary: This week many late Chinese Q4 earnings will be released with the most important ones being Tencent, Xiaomi, and Meituan representing the Chinese digitalisation. We also focus on Adobe which is scheduled to release earnings tomorrow. We take a closer look at concepts such as growth decay, free cash flow generation, and equity valuation theory, and how these concepts under certain assumptions can lead to an outcome matrix on expected return on Adobe shares.
The earnings season is still thin as we are waiting for the Q1 earnings season to kick off in three weeks. But this week we will get a lot of late Chinese Q4 earnings from many major energy, industrial, and banking firms. For emerging markets and the Chinese equity markets overall, the three most important earnings to watch are Tencent, Xiaomi, and Meituan, that represent the Chinese digitalisation. The list below shows all the 30 most important earnings this week.
Monday: China Resources Beer Holdings, Country Garden Services, Tencent Music Entertainment
Tuesday: Wuxi Biologics Cayman, Haidilao International, People’s Insurance Co Group, Geely Automobile, Adobe, IHS Markit
Wednesday:PetroChina, Xiaomi, ANTA Sports Products, China Mengniu Dairy, Tencent, General Mills, E.ON
Thursday:China Mobile, China Life Insurance, China Evergrande New Energy, Nongfu Spring, CNOOC, Anhui Conch Cement, China CITIC Bank, Country Garden
Friday: China Construction Bank, China Petroleum & Chemical, China Shenhua Energy, Bank of Communications, Longfor Group, Meituan
Adobe: lessons of growth decay and valuation
In this week’s Earnings Watch we will focus on Adobe scheduled to release earnings tomorrow. This is a company that has always been successful and carved out strong niche business delivering software to the creative industry. April 2012 was a transformational year for the company as it released its Adobe Creative Cloud SaaS platform and over time moved more and more customers to the platform. This was the end of on-premise business model and the beginning of a recurring subscription-based business model with more stable revenue and profitability.
The massive increase in predictability of the business is visible in the free cash flow to revenue time series (see chart below. The business model change happened by accident around the same time long-term interest rates began to go down significantly. As we discussed at length with clients this created bond-like valuations of predictable and high-growth assets such as Adobe. The free cash flow yield went from 11% in 2011 to 2% in 2020.
We have long wanted to write about growth decay concepts and equity valuations, and now is a good time and Adobe is a great example. Many variables influence the value of a business but for a high growth company the key is the growth decay, which is how fast and at what level revenue growth will stabilize? The second key variable is what the free cash flow generation profile will be like. For our example and with the knowledge we have today about the industry, Adobe’s market position, and the current trajectory of revenue and free cash flow, the table below shows a likely projection of Adobe’s business until 2028.
| Year | Revenue | Free cash flow | FCF / Revenue | Revenue growth |
| 2010 | 3800 | 943 | 0.248 | |
| 2011 | 4216 | 1333 | 0.316 | 0.110 |
| 2012 | 4404 | 1229 | 0.279 | 0.044 |
| 2013 | 4055 | 963 | 0.238 | -0.079 |
| 2014 | 4147 | 1139 | 0.275 | 0.023 |
| 2015 | 4796 | 1285 | 0.268 | 0.156 |
| 2016 | 5854 | 1996 | 0.341 | 0.221 |
| 2017 | 7302 | 2735 | 0.375 | 0.247 |
| 2018 | 9030 | 3763 | 0.417 | 0.237 |
| 2019 | 11171 | 4027 | 0.361 | 0.237 |
| 2020 | 12868 | 5308 | 0.412 | 0.152 |
| 2021 | 15210 | 6388 | 0.420 | 0.182 |
| 2022 | 17400 | 7482 | 0.430 | 0.144 |
| 2023 | 19784 | 8705 | 0.440 | 0.137 |
| 2024 | 22158 | 9971 | 0.450 | 0.120 |
| 2025 | 24374 | 10968 | 0.450 | 0.100 |
| 2026 | 26324 | 11846 | 0.450 | 0.080 |
| 2027 | 28035 | 12616 | 0.450 | 0.065 |
| 2028 | 29437 | 13246 | 0.450 | 0.050 |
Source: Bloomberg and Saxo Group
In our example we are modeling a gradual decline in the revenue growth stabilizing around 5% in 2028 and the free cash flow generation on revenue increasing from 41% in 2020 to 45% in 2024 and stabilizing. Under these assumptions, revenue will grow to $29.4bn and free cash flow to $13.2bn in 2028. What is a business of this kind worth in 2028 and what does that translate into in terms of expected returns? The free cash flow in 2028 will have to have a discount factor and for equities this is basically the required rate of return, which is the sum of the risk-free rate and an equity risk premium.
On various scenarios for the US 10-year yield and the equity risk premium we get a range of possible annualized returns from the current market value in March 2021. In the one extreme we get a high 30.5% annualized return over until 2028 if our assumptions come true and the US 10-year yield and equity risk premium collapses to 0.5% respectively, and -0.4% annualized if the equity risk premium goes to 3.5% and the US 10-year yield goes to 3%. What is the equity risk premium likely to be in 2028? The historical average for US equities has been around 5% but the nature of Adobe’s business and the predictability of cash flow means that it should be lower. Somewhere between 2-4% is not unreasonable. The example is not to provide an investment recommendation of Adobe but to show how various assumptions and changing their values produces an outcome matrix that can be used for decision making.
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