Palm Capital has High Hopes for Adobe Inc. (ADBE), Here’s Why

Palm Capital, an investment management firm, published its first quarter 2021 investor letter – a copy of which can be downloaded here. Over the three months ending 31 March 2021 the portfolio increased by 3.1% after management fees & trading expenses. Over the same period our benchmark, the MSCI World Index, increased by 4.5%. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.

Palm Capital, in their Q1 2021 investor letter, mentioned Adobe Inc. (NASDAQ: ADBE), and shared their insights on the company. Adobe Inc. is a San Jose, California-based computer software company that currently has a $234.9 billion market capitalization. Since the beginning of the year, ADBE delivered a -1.76% return, while its 12-month gains are up by 37.96%. As of May 03, 2021, the stock closed at $503.46 per share.

Here is what Palm Capital has to say about Adobe Inc. in their Q1 2021 investor letter:

“Adobe has a near-monopoly in content creation software with dominant applications including Photoshop, Lightroom and Illustrator that are critical in the lives of creative professionals. These applications are not only the best in the industry but also have high switching costs as it takes designers many years to become adept at using them. This investment of time is a sunk cost and makes it costly for designers to switch to an alternative. Additionally, as most creative professionals use Adobe’s suite of products it also has a network effect advantage – creative professionals use it because most other creative professionals do.

This creates stickiness of revenue, the visibility of which is enhanced by the fact that more than 90% of Adobe’s overall revenue is subscription-based and a large portion of this is paid in advance.

As Adobe’s programs have already been developed and they are now largely distributing this over the internet, the company’s gross profit margins are a towering 85%.

Adobe also has great economics. It is capital light. This means that it does not need physical assets like machinery, property, or stock to operate. As its assets are intangible, it does not need to take on debt to finance them. And its marginal cost of serving additional customers is minimal. The company is highly cash generative, not only because some of its revenue is received upfront, but also because it pays a large portion of salaries with shares and share options. This is evident from its balance sheet – it has had a large net cash position for seven of the past ten years. Furthermore, investments in its intangible assets are expensed rather than capitalized resulting in a low tax burden relative to typical capital-intensive businesses.

Finally, Adobe has lots of room for growth. The shift to digital creates a strong underpin for demand growth over the long term. And Adobe’s switching costs give it the power to grow revenue by increasing prices. Additionally, the subscription model is growing Adobe’s market in several ways. Firstly, it makes it affordable for small businesses, opening a new market to Adobe. Secondly, by freeing up IT capex and fixed costs, the model also makes it more affordable for large businesses, incentivizing them to take on pricier options. Thirdly, as the company is not updating its products that were sold under the licence model, the subscription model is beginning to capture many non-compliant users.

Over the next ten years, we expect Adobe’s sales to more than double and its free cashflow margin to expand to almost 40%.

These characteristics make Adobe an exceptional business and it is one half of the reason we have been invested for nearly three years.

This example as well as our examples of the aggregators earlier illustrates the impact that the internet has had in not only creating more profitable, less capital-intense businesses but also in allowing businesses to grow to much larger sizes at a much faster pace than before. It partly explains the pace with which new businesses are reaching $100bn valuations whether on public or private markets.”

Our calculations show that Adobe Inc. (NASDAQ: ADBE) ranks 16th in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, Adobe Inc. was in 114 hedge fund portfolios, compared to 106 funds in the third quarter. ADBE delivered a 1.07% return in the past 3 months.

The top 10 stocks among hedge funds returned 231.2% between 2015 and 2020, and outperformed the S&P 500 Index ETFs by more than 126 percentage points. We know it sounds unbelievable. You have been dismissing our articles about top hedge fund stocks mostly because you were fed biased information by other media outlets about hedge funds’ poor performance. You could have doubled the size of your nest egg by investing in the top hedge fund stocks instead of dumb S&P 500 ETFs. Here you can watch our video about the top 5 hedge fund stocks right now. All of these stocks had positive returns in 2020.

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Disclosure: None. This article is originally published at Insider Monkey.