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On Thursday morning, Adobe ADBE announced it was buying Figma for $20 billion. Over the next two trading sessions, Adobe’s market capitalization declined $34 billion1.

That seemingly wonky math could be explained by several factors:

• Adobe overpaid in acquiring Figma at close to 50 times its year-end ARR (annual recurring revenue);

• Adobe’s fiscal third quarter earnings report was mixed, and on its own probably would have driven some downside in ADBE stock;

• Perhaps most importantly, the decision to (from this perspective) overpay for Figma highlights the external threats to Adobe’s business. Crucially, it is an admission from Adobe management itself about the risk posed by those threats.

In that telling, the decline makes some sense. So does the fact that ADBE lost 24% for the week, and trades not only at a 29-month low, but 9% below where it did at the beginning of 2020.

That may not be the right way to view this story, however. The Figma deal appears more logical, and (possibly) less of an overpay, than the initial reaction suggests. Q3 earnings and Q4 guidance were mixed, but not nearly enough to drive an epic sell-off. And with ADBE now trading at a suddenly reasonable valuation, there’s a solid case that last week’s plunge is an opportunity.

Adobe Acquires Figma

Clearly there’s a three-way split in how the Adobe-Figma tie-up is viewed.

Equity market participants are skeptical, particularly of the price paid. Per the Adobe release, Figma should generate revenue this year of over $400 million; additional disclosure of ~$200M in added revenue in 2022 implies year-over-year growth likely in the high-80s on a percentage basis. Total present compensation of $19.7 billion2, including restricted stock granted to key Figma employees, suggests a price-to-revenue multiple in the 45x-48x range.

That’s a 2021-type multiple in a 2022 market. Snowflake (SNOW), the current leader in price-to-sales among large-cap software stocks, trades at 27x this year’s revenue.

Those in software and tech, however, seem more bullish. Figma is an exceptionally well-regarded company, as seen (to name just one example) in this post from 2020 titled “Why Figma Wins”. This Twitter thread details the qualitative case well:

Amal Dorai @amaldorai

I'm not surprised that Adobe is acquiring Figma for $20B, nor that Wall Street doesn't understand it and $ADBE stock is down more than $20B today. It's a smart move for Adobe because it's nearly impossible to make legacy software applications multi-user collaborative. Thread: 🧵

September 15th 2022

1,669 Retweets11,536 Likes

Posts elsewhere, including on Reddit3, laud the strategic nature of the vision, even if those reviews are less concerned with the price paid.

As for users, this Tweet perhaps summed it up:

Burak Dogramaci @BurakDogramaci

Our thoughts are with all designers who believed in this. #figma

September 15th 2022

377 Retweets1,544 Likes

But there’s a case that, in the long run, all three viewpoints actually look bullish for ADBE.

Did Adobe Overpay?

Let’s start with the fundamentals. It does seem likely that Adobe overpaid for Figma. Figma last raised capital 15 months ago at a $10 billion valuation. That itself is a fivefold increase from the 2020 level.

But since then, private market prices for software companies should have followed those of public markets. ADBE itself is down by nearly half since Figma’s 2021 raise was announced. And, indeed, the other ‘hot’ design startup in the space, Canva, has seen its private market value fall 54%. An investor could argue that, in the context of the sector, Figma’s current value should be closer to $6 billion (or worse?) than to $20 billion.

That said, the extent of the overpay might not be as large as broader market comparisons suggest. Again, SNOW is at 27x this year’s multiple. That company no doubt has a larger total addressable market — Adobe said on the Q3 call that Figma’s TAM was just $16.5 billion at 2025 — but its gross margins also are sharply below Figma’s ~90%.

Figma’s net retention rate is close to, if not quite as good. (~150% vs 171% for SNOW in Q2). Its overall revenue growth is better (again, likely mid- to high-80s against a Street estimate of 70% for Snowflake this year).

Given the declines in ADBE and Canva’s private shares, it would be simple to look at last year’s valuation and presume that Figma would have to raise at, say, $5 to $7 billion this year if it needed capital. That’s probably too conservative, however.

It seems likely that Figma had a strong 2022; despite an obviously difficult IPO market, its founders and investors weren’t willing to sell anywhere close to the 2021 valuation. Meanwhile, a SNOW comparison (which admittedly is imperfect) would argue that a 25x-30x revenue multiple is not out of line. That in turn suggests Figma is worth in the range of $11 billion to $13 billion.

Obviously, that’s not $20 billion. But for an investor buying ADBE at $300, the $20 billion figure is not necessarily the figure on which to focus. We’ll get to earnings later, but it’s clear that some of the $34 billion lopped of Adobe’s market cap on Thursday and Friday can be attributed directly to the price tag of the Figma acquisition. In fact, it seems likely that a material portion came simply from the purchase, including the fact that Adobe paid $20 billion for what the market believes to be an $8 or $12 billion business.

If that’s the case, from a fundamental perspective the deal cost is priced in. Legacy Adobe plus Figma for a ‘good’ price of $12 billion equals legacy Adobe $8 billion cheaper plus Figma for the ‘bad’ price of $20 billion.

To be sure, that’s a bit glib, and the math obviously can’t be done precisely. That aside, it is a qualitative concern that, from Q1 FY21 through Q2 FY22, Adobe spent $7.5 billion repurchasing stock at an average of $583, and then issued $10 billion worth of stock at $378.

Capital allocation for a dominant, mature business is paramount. The trade here looks suboptimal, particularly given there was or should have been some inkling a year ago that Figma eventually would be an acquisition target, and an expensive one at that.

Still, the point is that from a purely fundamental perspective, the fact that ADBE on Thursday announced an acquisition in which it (probably) overpaid doesn’t really impact the investment case on Monday. The market believes Adobe overpaid, and in the last two sessions adjusted the ADBE stock price accordingly.

Is Adobe In Trouble?

Moving on, the issue might not be just the price Adobe paid for Figma. It’s that it felt the need to make the move at all.

Here’s how JMP Securities analyst Patrick Walravens framed the deal on CNBC:

…Adobe’s been saying that the “creator economy” in the last few years has gone from 150 to, say, 300 million people. The issue has been that a lot of those new creators — you know, like my children included — they’re using…Canva, and they’re using Figma as opposed to Adobe.

The bearish interpretation of the deal, and the clear leverage that Figma had, is that Adobe essentially had no choice. Canva and Figma are taking revenue away from Adobe. Canva, as Walravens put it, “got away” from Adobe by reaching such a sky-high valuation; that left Figma for Adobe to buy. Presumably, Figma knew this, allowing it to negotiate a bull market price in the middle of a bear market.

But there are two points to make here. The first is that the risk of competition from both private companies was not unknown before the deal occurred. Soft guidance coming out of Q1 was attributed to competition. Morgan Stanley downgraded the stock in June for the same reason; BMO followed last week. Competitive pressures risked not only revenue growth but profit margins, for a company that literally is among the most profitable in the entire market.

Even at Wednesday’s close, ADBE had underperformed the NASDAQ 100 by 900 bps year-to-date, and by 1840 bps from Nov. 1. Canva and Figma were likely a big reason why4.

It’s exceptionally dangerous in a case like this to argue that slowing growth and/or margin compression is ‘priced in’. But that’s not the only point we’re making here. ADBE closed at $371 on Wednesday because of competitive risks. From Q3 FY21 through Q2 FY22 (the four reports before last weeks), one-day post-earnings returns in ADBE were -3%, -10%, -9%, and -1%. There were macro and FX concerns in there as well, but investors (and analysts on earnings call) clearly were fretting about the two startups.

Perhaps Adobe’s move is a sign that competition is taking more of a toll without broader headwinds (notably, a slowing down in the creator economy). Adobe had said in the past that it was managing the competitive environment; for instance, CEO Shantanu Narayen insisted after Q1 that its launch of Creative Cloud Express was “not driven in any way, shape or form by any competitive response.” Presumably, to at least some extent, this $20 billion acquisition was driven by a “competitive response.”

Why Figma Makes Sense

Now perhaps we’re getting closer to justifying the steep decline in ADBE over Thursday and Friday. The company wasted money on the Figma purchase, and signaled that its competitive positioning was weaker than investors believed. Cash flow already was going to buy back shares issued to employees simply to prevent dilution; now more of it is going to a major acquisition target as well.

But, again, investors previously understood competition to at least some extent. And the second, more important point is that investors now need to understand precisely what that competition is.

Again, the creator economy has roughly doubled in size, at least in terms of users. But the reason why Canva and Figma are winning with so many of the incremental ~150 million users is that the products are not just cheaper, but much easier to use.

Canva’s strength with those users is why Adobe launched CC Express. Figma’s strength is why Narayen on the Q3 call said that his company’s acquisition “might seem competitive, but [is] actually more complementary.” Figma moves Adobe out of the high-end (and higher-priced) technical market into a growing base of “no-code” users.

But Figma also promises to improve Adobe’s technical products. Let’s return to the Twitter thread linked to earlier:

Amal Dorai @amaldorai

I'm not surprised that Adobe is acquiring Figma for $20B, nor that Wall Street doesn't understand it and $ADBE stock is down more than $20B today. It's a smart move for Adobe because it's nearly impossible to make legacy software applications multi-user collaborative. Thread: 🧵

September 15th 2022

1,673 Retweets11,562 Likes

One common response to the Figma deal seems to be, “if Adobe is such a great company, why didn’t they just spend $10B in-house and run these two startups out of business?” But as Dorai explains, that’s not how it works. Between the very nature of a file, and the backwards compatibility problem (to older versions of the software), a legacy developer like Adobe builds up so-called “technical debt”.

What Figma can do, at some point, is allow Adobe to rebuild its existing programs on the company’s cloud-native, multi-user-friendly architecture. And that, in addition to expanding exposure to non-enterprise/less-technical customers, is a key part of the qualitative argument for the deal. It’s why tech people see the strategic wisdom (and this thread is just an example of that) of the acquisition.

Admittedly that still leaves Canva with a $26 billion valuation in a market that Adobe (in the bearish narrative) allowed it to access. But the ability of Canva and Figma to start from scratch provided a key competitive advantage. The acquisition of Figma removes one key competitor. The existence of Canva does not mean another (perhaps targeting another Adobe offering) will inevitably arise in the near future.

That’s particularly true because, technically speaking, Figma may well be better, despite its lower market valuation. Figma users are in an uproar over the acquisition because a) they’re designers and b) they love the product relative to Adobe XD. Conversely, Canva is “ramen [compared] to Adobe” Express (formerly Spark), with “a ceiling you’ll never pass…that Adobe can achieve.”

Earnings and Valuation

The perspectives of investors, users and industry participants all have value. The investor perspective (at least to some extent) is priced in. The strategic part of the deal does not appear to be.

It’s impossible to tell what extent the Figma acquisition accounts for the decline in ADBE on Thursday and Friday. But our guess is that it was the primary driver. Q3 earnings were mixed, with reported and guided revenue a little light, and EPS modestly ahead of consensus. It’s possible that share repurchases drove the bottom-line beat, but Adobe is still growing mid-teens constant-currency and margins are holding to the year-to-date trend.

All told, the Q3 report doesn’t look out of line against the last four releases, which on average saw a mid-single-digit post-earnings decline.

This brings us to this challenge with ADBE stock, and indeed the broader market. To summarize, our thesis is that one of the best businesses of this generation5 saw a two-session, 19% decline largely due to an acquisition that the equity market is misreading. Shares are now at a 29-month low and when accounting for share-based comp and current net cash trade at ~27x this year's earnings and ~24x normalized free cash flow.

Now, if this is the same old Adobe, those multiples still work, particularly because they don’t account for any value from Figma. A basic DCF, which accounts for dilution from the deal (and presumably profit contribution down the line), suggests $300 is pricing in ~9% cash flow growth for a decade, with a 2% terminal rate. Adobe has done much better than that looking backward, and if the Figma deal works it likely will do so going forward as well.

But those multiples are still steep. They highlight the valuation challenges still present in this market. An “unjustified sell-off” thesis usually should, and usually does, have a greater margin of safety built in.

There are a few ways around this problem. The first is to look at ADBE as a trade. If an investor believes this week/month will see a rebound in big tech, ADBE pretty much has to be at the top of the list. Any kind of return to “risk-on” or even “risk-acceptable” trading probably leads to bottom-fishing here.

The second is to look to the options market. Selling puts, to either get ADBE at a lower multiple or garner some premium. The March 2023 240 put, for instance, creates either a 5%-plus return (~11% annualized) or ownership at a touch under 20x 2022 normalized free cash flow (again, with no contribution from Figma).

And the third is to simply move ADBE up the shopping list in the event the tech correction/sell-off/bubble-burst continues. (Fourth presumably would be a pairs trade, long ADBE/short QQQ or long ADBE/short software X, but that strikes us as a little too cute.)

Whatever the merits of the specific response, the reaction by the market last week does appear to be an overreaction. This deal makes strategic sense. It doesn’t imply, as skeptics would argue, that Adobe’s best days are behind it.

It certainly doesn’t warrant a $34 billion decline in Adobe’s market capitalization. The key question, then, is if the market cap was simply too high to begin with.

As of this writing, Vince Martin has no positions in any securities mentioned. He may initiate an equity and/or options position in ADBE this week.

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