Earnings Watch: Will the Adobe money machine continue?
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,
Thursday:China Mobile, China Life Insurance, China Evergrande New Energy, Spring, CNOOC, Anhui Conch Cement, China CITIC Bank, Country Garden
Friday: China Construction Bank, China Petroleum & Chemical, China Shenhua Energy, Bank of Communications, Group,
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|
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.
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.