“In this world, nothing is certain except for death and taxes.”Benjamin Franklin
Benjamin Franklin’s famous comment originally referred to the underlying fragility of even something as seemingly permanent as the newly ratified US Constitution and wryly contrasted it with both his impending mortality and his disdain for federal taxation. Journalists and football managers have been known to append a third term relating to something they regard as highly probable, often for comic effect. Unfortunately for us as fund managers, there really is no dead cert. Nowhere is this truer than in the cutthroat world of mergers and acquisitions. Their characteristic uncertainty is one of the reasons why we are sceptical of acquisitions, especially large ones, and why we put such an emphasis on our companies generating persistent levels of organic growth from sustainable means.
When Adobe announced its intended acquisition of Figma in September for a record fee of $20bn1, we were confronted by the quandary of trying to give a conclusive answer to something inherently unclear: whether this was a good or bad acquisition. Unlike the short-term traders and sell side brokers who need to come to a conclusion within hours, as long-term investors we have the time to come out with a more considered response. As is so often the case when one of our companies hit the headlines, we received a flood of questions which we could not answer at the time. With the dust having settled somewhat, we thought it might be interesting to now answer some of those questions.
The immediate response
Adobe is best known for its pdf reader and Photoshop tools. Over the course of 40 years it has become the dominant force in creative software, forming a critical part of the work processes of photographers, graphic designers, film makers and artists. This offering, known as the Creative Cloud, forms the bedrock of the business, and accounts for 60% of revenues.2 It convincingly passes our Ten Golden Rules, with its dominant market share, predictable recurring revenues, high margins and an impressive record of organic growth which has seen its revenues grow at a 20-year CAGR of 15%.
First launched in the early 1990s, the photo editing tool Photoshop remains the most important within Adobe’s Creative Cloud. One of its key differentiating features is its ability to design high fidelity (extremely detailed) content that can be blown up onto billboards, and hence it is used by graphic designers the world over. Figma is much less well known, unless you happen to be a graphic designer or a developer. Founded ten years ago, it has become the leader in a subset of graphic design, called “User Experience” (UX). This simply means content designed purely for digital output, most notably designing the interface of websites and apps. Figma’s remarkable success has come from the fact that it is both cloud-native, designed to work specifically through your web browser, and collaborative, enabling multiple people to edit and make suggestions at the same time.
On the face of it, Adobe’s management were hitting three birds with one stone: buying in innovative tech; adding in a new avenue for growth; and taking out a potential competitor. This positive reaction evaporated on discovering the price paid. At $20bn, Adobe would be paying 50x sales, an eye watering multiple, even in the world of tech. Such a high price, with half being offered in equity, led to two immediate concerns: earnings downgrades in the near term (as the issuance of new shares would push down the earnings per share of the company) and the worry that they had been forced to pay such a high price out of desperation. One wall street analyst neatly reflected the immediate hysteria:
“It’s a shocker, this company has been incredibly disciplined on their capital allocation, they have never chased an acquisition with this multiple…. Most investors are like, “there’s something wrong, this is defensive.”….This is a phenomenal management team with a phenomenal franchise that is beloved by customers. [But] I have never seen the level of investor hatred towards a deal.”3
Fears that the Creative business may have reached full penetration and be on the cusp of slowing have circulated around Adobe for many years. This deal was taken as proof that Figma was stealing share from Adobe, causing its Creative business to slow and leaving management with no option but to buy the upstart competitor. The market response to this kneejerk conclusion was not good, as evidenced by a plummeting share price4 and the histrionic reaction of brokers and journalists.
And yet, Adobe’s core business had, in reality, only endured a minor slowdown in 2022, and most of this could be explained by the valid excuses of a strong dollar, the war in Ukraine and tough growth comparisons from the prior year. Furthermore, its growth in the years running up to 2022 had been very strong, hardly the sort of performance that would necessitate such a desperate move. Second, Adobe’s management is well known for its prudence and conservatism. It has always focussed on profitable growth, and on keeping a solid balance sheet with net cash. While desperation was the most obvious answer to the high price paid, it seemed equally obvious to us that this couldn’t have been the only reasoning.
A more measured approach
Over the next few days we held calls with numerous experts and it was striking that, despite the clear complexity of the matter, most of them had strong, definitive views as to the rationale behind the deal. The impulse to have a conclusive view seemed to, once again, supersede acknowledgement of nuance. We took our time to consider these views, to read the numerous articles online and in the press and, most importantly, to discuss all the arguments with the team, drawing three important conclusions.
First, Adobe’s hold over its core customers was as strong as ever and its growth potential remained intact. Most of Adobe’s customers will be using their Creative Cloud subscription for multiple tools. Even a design agency, whose main use will be Photoshop, will have demand at some stage in any year to use Lightroom (image storage), Illustrator (vector graphics) or Premiere Pro (videos). Creative Cloud gives them this flexibility for only $800, a tiny fraction of their total running costs. Figma hadn’t changed this. In relation to future growth, the rise of Figma had seemingly prevented Adobe from gaining a foothold in the world of UX design. But UX is only a small portion of the overall design market, as demonstrated by the fact that Figma’s $400m in revenues, the lion’s share of this market, is only 2% of Adobe’s total revenues. It was too small to have a major impact on growth rates, and surely not worth harming management’s reputation in this way. Second, the acquisition did not mark a change in strategy. While management have rightfully developed a reputation for prudence, infrequent large landmark deals have also been a feature of Adobe’s history.
Reassured that none of our Ten Golden rules had been broken, the third and final question around the lofty price remained. What soon became clear was that, when looking out over the long term, this deal had the potential to generate significant value.
There are large cross sell opportunities, opening Figma up to Adobe’s large installed base of almost 30m paid subscribers, and introducing Adobe to the so far untapped developer market. Even more important is the acquired tech, bringing across Figma’s expertise in collaborative browser-based apps. This may not sound like the most complex technology, but the truth is that it is incredibly hard to build an intricate design tool, which can be updated instantaneously, across multiple locations.
The potential goes beyond the cross pollination of their existing apps and technologies, though. Figma is a platform that, when combined with Adobe’s expertise and $3bn R&D budget, could be used to build the next dominant software that emerges in creative design.
So, we concluded that this wasn’t foremost a defensive move to help boost growth, though it will do that. And it wasn’t simply about removing a competitive threat, though it does do that also. The most exciting aspect of the deal, and the aspect which could justify the large price paid, was the potential to create new products and new markets, in which they will be the dominant player.
So, if we extend our analysis beyond the two year time horizon over which most of the market obsesses, the large price becomes more justifiable.
There are a few further points that should be made when considering the price and the rationale of this deal. First, Figma was not a generally available asset. With the success it had enjoyed, it was primed for an IPO in 2022 or 2023. The market sell-off put those plans on hold, leaving a small window in which Adobe could make a successful bid. Second, Adobe had been circling for some time, making approaches in 2020 and 2021, demonstrating this was not a short-term, reactive move. Third, no other acquirer could have achieved the same level of synergies and growth potential. A deal which looks expensive to these other companies is therefore much more reasonable to Adobe.
One final question then remains: why did Figma agree to the deal? The obvious answer is money. But Figma’s CEO, Dylan Field, would have known an equally lucrative IPO was in touching distance and besides, he doesn’t strike us as someone motivated purely by private jets and Californian real estate. It may be that he realised the potential for Figma was far greater when combined with Adobe, than if they tried to go it alone. And this is one of the reasons why he requested to be paid a greater share in Adobe equity than in cash.
Conviction in our process
Acquisitions add a further layer of uncertainty and risk to the already difficult task of investing in companies. More often than not, they end up being expensive distractions, but occasionally they are justified. Some more optimistic observers have compared the Figma deal to Facebook’s acquisitions of Instagram and WhatsApp for $1bn and $19bn respectively. At the time, both were seen as astronomical; it now looks like they will pay for themselves many times over. Yet those were just ring-fenced, single apps. More apposite comparisons lie closer to home, with Adobe’s acquisition of Macromedia in 2006 and even their original acquisition of Photoshop back in 1993. The latter cost them $34.5m but is now arguably responsible for $5bn in revenues and was the foundation upon which they built most of their other creative apps.
We don’t take any pleasure in seeing one of our companies fall -20 per cent. As our investors can sympathise, the immediate reaction is to think that something disastrous has occurred. However, if the underlying business has not deteriorated, we view this fall as an improvement in future returns. We can’t be certain of many things in life, and we are not saying that this Figma deal will definitely be a success. After all, it still requires regulatory approval and even then, integration risks remain. But we do believe that the only way to properly analyse a situation is to give yourself the time to assess all the possible scenarios. That is why it is important to have a well-resourced research team, to help us get to the right answer rather than the immediately obvious one.
31 January 2022
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