When Adobe (ADBE) announced the $20 billion acquisition of Figma last week, investors were wildly disappointed. That disappointment cost Adobe $35 billion in market cap including the $1.6 billion that Adobe shed today. We mostly focus on the acquisition of public companies and merger arbitrage spreads on those deals, but this deal was fascinating on multiple fronts. Most investors were wondering what exactly Figma was and why Adobe would pay so much for a company that is expected to generate $400 million in 2022 revenue, putting the price tag at 50 times sales. Didn’t we just go through the popping of a software bubble, especially in SaaS stocks?
With the exception of security software companies, most SaaS companies are now being valued at somewhere between four to six times forward sales. Despite the big drop in Adobe’s stock in recent days, it still trades at a small premium of eight times forward sales. The stock, which had dropped 34% year-to-date before the deal was announced is now down nearly 48% YTD. The deal for Figma will be half in cash and half in stock. Given the drop in Adobe’s stock since announcement, it is likely that the total value of the deal will eventually end up being lower than the $20 billion headline number.
My background is in designing databases and building software. When it comes to front-end design or user experience (UX), I am blind as a bat. When we started planning the launch of our seventh investment strategy on InsideArbitrage, we retained the services of a designer and he ended up using the design software Figma to build screens for us to review. Unfortunately the Figma screens do not automatically convert into code that can display webpages on a desktop or mobile browser. We were able to partially solve for that issue through the use of another piece of software that plugs into Figma. This extensibility and the lean nature of the software compared to Adobe’s legacy tools like Illustrator and Photoshop has endeared designers to Figma.
A decade ago, Adobe was heralded for managing a challenging transition from shrink-wrap software that was delivered through CDs/DVDs to cloud software. Like most companies that attempted this transformation, revenue dipped in the early years and net income was hit even harder. Net income dropped sharply from $833 million in fiscal 2012 (ended November 2012) to $290 million in 2013 and even lower the next year. Adobe’s CEO Shantanu Narayen was credited for transforming the business, which during the trailing twelve months generated $4.8 billion in profits, nearly six times its income from fiscal 2012 and an incredible 18 times the net income from the fiscal 2014 lows.
What spooked investors about the Figma deal was not just the high multiple paid for the business but the signal that Adobe was sending about its future growth. The company reported third quarter 2022 revenue of $4.43 billion and forecast Q4 2022 revenue of $4.52 billion compared to analyst estimates of $4.6 billion. A growth stock is at a disadvantage in a rising interest rate environment and once you add revenue deceleration to the mix, you end up with a mess. The announcement of a very expensive acquisition was the last straw for investors and it is not surprising to see that the stock hasn’t even seen a dead cat bounce.
More than two decades ago, I used to use a suite of products from a company called Macromedia to build web applications. One of their products was marketed as something that could automatically build web applications by converting visual design to code. As is often the case, the resultant auto-generated code was unfortunately a mess but Macromedia still provided a valuable set of tools for web designers and developers. Macromedia was a public company and Adobe acquired the company in 2005 in an all stock deal valued at $3.4 billion.
Macromedia reported net income of $41.5 million on revenue of $370 million in 2004, indicating Adobe paid 9 times sales and a very generous 82 times earnings for its competitor. The deal was too early in my investment journey and I had not heard the words merger arbitrage back then to know what the spread on the deal was after announcement. Both stocks dropped in unison as investors were not pleased with the announcement of the Macromedia deal despite assurances that Adobe planned to buyback up to $1 billion of its stock.
While the Figma deal in many ways is similar to that Macromedia deal, it reminds me more about the $19 billion Facebook paid for WhatsApp in 2014. WhatsApp had scant revenues when Facebook announced the acquisition and it was clear that Facebook needed the acquisition as it looked towards future growth and to eventually transform itself into Meta Platforms (META). Despite the big recent pullback, Meta’s stock is up more than 100% since the time the WhatsApp acquisition was announced and the stock has outperformed the S&P 500 but not the Nasdaq.
Mr. Narayen took the top job at Adobe in December 2007 and managed the company through the Great Recession and the transformation from a shrink-wrapped software to a SaaS company. If he can deliver results that are half as good as what he pulled off during the last decade, investors will be able to look past this very expensive acquisition. If he instead continues to chase growth (or stifle competition) through large acquisitions, then investors will be less forgiving and Adobe’s stock is likely to underperform the indices in the coming years.