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3Q26 Financials.
Adobe reported fiscal 3Q26 and the stock was down ~2% after hours, but recovered most of that the next day. Post earnings sell offs have been common for Adobe, where they’ve sold off in 11 of the past 13 quarters, suggesting that the market is looking for a clear narrative change, which this quarter did not provide. There was evidence for both bulls and bears to support their pre-existing theses.
Revenues grew +13% y/y (+12% constant currency), which was a ~60bps beat relative to the high end of management’s last quarter guidance. ARR growth decelerated for the 11th consecutive quarter. (Recall that the optically elevated ARR in 2Q26 was the result of the Semrush acquisition, which added $480mn in ARR, absent of which ARR growth would have been closer to 10.5%). This quarter’s ARR growth was 11.2%, but backing out the Semrush acquisition it would be closer to 9.3% y/y. No doubt this continued decline in growth rates has caused investor uneasiness.
Management has attributed this growth slowdown primarily to the shift to a freemium model, which creates more top of funnel usage, but increases the time it takes for them to monetize that usage. The other smaller factor is that their Adobe Stock Image business (~$450mn last disclosed in 1Q26) is under pressure from generative AI images. It is a bit perplexing why they don’t break this business out separately as it is clearly in structural decline and could help investors better understand the underlying business. (Though, at last disclosed it pressured ARR growth by about 30bps, so perhaps it isn’t a large enough drag to change the narrative meaningfully.)
Management continues to vocalize that the freemium strategy is working with creative freemium users growing +70% y/y to hit 100mn MAUs. Below incoming CEO Anil Chakravarthy notes that the funnel is growing and the downstream monetization with Firefly credit packs is starting to work with monetization of the freemium funnel. Firefly ARR was +40% q/q.
It is hard to know for sure though that this freemium usage will ever convert. Management likes to talk about their old strategy of how they made PDF readers free to use and then later monetized with Acrobat to edit PDFs, but how much this analogy holds is a bit of a question mark as there are already many popular alternatives in the low to mid end space (Canva is a primary competitor, but there are others across their apps in addition to free AI generative usage from most model providers). The hope seems to be if they drive enough usage and get users to create a habit on Adobe Express and their other Creative products, they will be able to eventually push them into paid plans or upsell existing creative suite users.
While this strategy makes sense, it will be a while before we know if it pays off. In the meantime, what we do know is that they are bearing the cost of these freemium users who subscription cost grew +24% y/y against subscription revenue growth of +14%, taking subscription gross margins down ~80bps. That gap has widened every quarter this year: subscription COGS grew +10%, then +16%, then +24%, while subscription revenue growth held steady around ~14%.
Now this 8 point increase in COGS growth q/q (the +24% growth this Q vs +16% last Q) is largely the result of the Semrush acquisition, but it still holds that COGS are growing faster than revenues. This becomes even clearer if we look at the underlying COGS drivers, which has been offset by an amortization tailwind. (The disclosure below is from their 2Q 10-Q, since their 3Q 10-Q isn’t out yet, but this trend is largely the same. Amortization was probably a ~2 point smaller tailwind in 3Q).
This is likely because they are serving more costly AI features and not charging commensurately for them, leading to gross margin pressure (one of the risks we entertained in our Adobe Deep Dive).
Now this trade off could be worth it. Taking a small gross margin hit to grow top of funnel usage makes sense. The other aspect of this worth remembering is that they deferred the Creative Cloud price increases. Their annual ARR target at the beginning of 2026 was 10.2%, which was never raised when they acquired Semrush (Semrush did ~$480mn in ARR at the time, which implied a 2 point shortfall to their original target). This was interpreted by many investors as a de facto lowering of their annual revenue target.
Last quarter they noted that half of the ARR shortfall was from not taking pricing up on their Creative Cloud plans and the other half is from diverting traffic to the freemium strategy.
Below Anil reiterates that traffic has been diverted to the freemium funnel.
There still is the lingering question though that if they were so confident in their position, then why would they defer the price increase? The concern is competition is weighing on their ability to raise prices and they feel the need to provide more value and create more user habit before they increase prices.
RPO (remaining performance obligations) is a forward-looking figure, and it slowed to +8% y/y, the first single digit growth rate since 2023. When an analyst asked about it on the call Shantanu said that it was consistent with the ARR trend (remember ex-Semrush ARR is growing closer to 9%). He then gave the same freemium reasoning to explain it, which explains part of it, but cRPO (current RPO) grew a little more at +9% y/y. The cRPO is just the piece of RPO due in the next twelve months, so the fact that it grew faster than the total means the longer-dated portion, where the multi-year enterprise contracts sit, is growing the slowest. That isn’t something the freemium strategy accounts for, making it a bit of an unsatisfying answer. The clear take away though is that Adobe’s revenue growth deceleration isn’t on track to reverse anytime soon.
Their Business Professional & Consumers segment, which includes Acrobat, Adobe Express, and Firefly, grew +16% y/y to $1.91bn in subscription revenue. Their Creative & Marketing Professionals segment, which includes all of their Creative Suite and the old Digital Experiences business grew +13% y/y (or ~10% ex-Semrush) to $4.65bn. Later in the call though they noted that Adobe Experience Manager, Adobe Genstudio, and Adobe Experience Platform grew ARR >20% y/y. This suggests that their core Creative Suite is growing well below that 10% segment consolidated figure.
Perhaps one of the reasons they resegmented the business was to better hide this growth deceleration in what used to be the Digital Media business. Growth in the Creative & Marketing segment is expected to further decelerate in 4Q to 10% (or perhaps ~7% stripping out Semrush). Management continues to point to the growth in non-financial metrics to assuage concerns: 100mn freemium MAUs +70% y/y and 1bn total MAUs +20% y/y, but it is still an unsettling level of growth deceleration. (We will pick back up on this conversation in the business commentary section).
Moving down the P&L, total operating income was +8% y/y vs revenue growth of +13% as opex was +15% y/y (driven by increased R&D and G&A, offset by slower S&M growth). It’s worth mentioning that Semrush is diluting their operating margins.
From a financial perspective, this quarter was fine. They beat management’s guidance and slightly raised their full year revenue guide by $26mn, but kept flat their ending ARR growth guide (they called out a slight FX headwind in the back half of the year). Their old guide is compared to their new guide below.
In the quarter they repurchased ~$2.3bn of stock, bringing diluted shares outstanding down to 395mn, a -1.8% reduction q/q. They note they have $24.55bn left on their existing stock buyback authorization.
The bigger questions with Adobe have less to do with their recent financial performance and more with their pending strategy shift and how they expect future users to interact with their software suite.
Business Commentary.
The incoming CEO of Adobe is Anil Chakravarthy who was The President of Customer Experience Orchestration Business (referred to as CX) before becoming CEO. This business used to be called Digital Experiences but was renamed to emphasize the agentic workflows. There is a growing chorus of executives (including the incoming CEO) who believe agentic work will be the next “platform” shift and Adobe must manage it like they did prior licensing to SaaS transitions.
The question of what it meant that they appointed the former head of Digital Experiences instead of Digital Media (David Wadhwani) meant for the business was asked point blank on the call:
In our opinion, this was a fumbled opportunity to better explain why they picked the head of Digital Experiences instead of Digital Media given that the latter is ~75% of revenues (these are the former business segment names). What we would have wanted to hear was a clearer thesis on why they picked someone with experience from the agentic side of the business. It is likely (although they didn’t exactly spell this out) that their concern is that work increasingly starts in different AI interfaces that invoke Adobe’s software suite. This would mean AI agents are using Adobe tools instead of human users. Anil would have better experience running the business through this transition.
The decision to pick Anil makes sense in this light, but it hasn’t been explained well in our opinion. The Creative and Marketing Professionals segment is struggling the most from a revenue perspective, but management’s commentary still insists that this is self-inflicted from their freemium strategy. It leaves open the question that if this was a well advised strategy that is working then why was Anil picked over David Wadhwani, who oversaw the much larger creative business?
The two potential answers are either 1) that agentic AI is the future and we need someone like Anil to lead us through that transition or 2) the freemium strategy in the old Digital Media business that David Wadhwani oversaw was not performing well and so why would we double down on the person leading that segment?
The answer could be a mix of both, but it does seem to endorse the idea that the freemium strategy isn’t really the sole cause of the pressure in the Creative Apps business (remember the new segment includes creative cloud apps and the old digital experience business, but the disclosures allow us to know that the creative apps business is growing significantly less than that segment’s overall ~10% ex-Semrush growth).
The other part about the CEO transition that seemed off was that they announced Shantanu was stepping down in March before they knew who the next CEO would be (which wasn’t announced until the beginning of September). This is typically done if they wanted to open up the CEO search to external candidates and does not seem like it was truly a decision between Anil and David. It leaves us with the impression that they are more worried about disruption and are a bit unsure of the best strategy forward.
This all seemed to have been encapsulated in the non-answer Anil and Shantanu gave when asked whether Anil’s digital experience background is a statement on where the board thinks the future of Adobe’s growth opportunity is. It is a confusing mix of messages from Adobe who claims that their freemium strategy is working while passing over the executive who ran that strategy. Instead, they picked an executive who frames the current paradigm as a platform transition on the scale of on-prem to SaaS, which suggests there are concerns the deceleration could be structural rather than a self-inflicted timing choice on when to monetize users. Shantanu noted on the call that they were “really happy” they didn’t raise prices because it would have only provided short-term relief. But for years price increases were a mainstay for Adobe and not a means to address user adoption issues. While this was specifically in reference to the Business Professional & Consumer segment, they similarly have deferred price increases on the creative suite.
This reminds us a bit of Warren Buffett’s comment that you don’t have a good business if “you have to hold a prayer session” before raising prices. The more charitable reading is that they want to increase usage to drive habit to better entrench new users in a workflow before increasing prices, but it still suggests a weaker competitive position and why that is not entirely clear because it still is true that they have a dominant creative app suite for professional usage. This is all to say it just feels like there is something more going on that is hard to fully grasp given existing disclosures. Seeing a price increase go through on the creative suite would help assuage these concerns.
If we had to interpret their strategy though it is to continue to be the leader in asset modification and remain agnostic as to how their tools are used. Anil noted that they are seeing the interfaces potentially change with how users interact with their software suite and they want to enable those changes:
The Topaz acquisition also makes strategic sense in this light. Topaz Labs specializes in enhancing videos, which is consistent with how they have talked about generative AI being used alongside Adobe. Adobe will enable users to use dozens of different models to generate creative assets and will continue to be the layer that users use to adjust those creative assets. You don’t have to use any AI generative tools for long to figure out they are very imprecise and poor at making small adjustments to pictures or videos and software tools are still a far superior solution than continually prompting a model.
While a lot of the commentary we gave on Adobe and their messaging isn’t positive, it still remains hard to see exactly how they would be disrupted. AI model companies are not currently trying to create competing high end software tools and Adobe has been a beneficiary of generative AI in that it creates more of a need to modify creative assets. While there are several competitors (see our full competition discussion in our deep dive), there is no current direct competitor for the high end work they do. Adobe Express is successfully gaining usage to stop the bleeding at the lower end of the market from Canva. And while growth is slowing, you don’t really need much growth at the current valuation for an investment to work (as shown in the reverse DCF below).
It also isn’t impossible to think they will push through a price hike next year and start monetizing the freemium funnel, which reverses the revenue growth contractions and a lot of investor concerns. As we noted in our Adobe deep dive, there is no real one clean kill shot to Adobe, which is what makes analyzing Adobe so hard.
Below we reprint our analysis from our deep dive, which we think is still true:
That is all to say that despite all of the scary AI threats, in Adobe’s core business of asset modification, there are few players that can do what they do today. Instead, the risk generally is that fewer people need to modify assets at all. AI doesn’t really change the competitive factors in their other business of delivering assets. Everyone will incorporate AI in their products and so will Adobe. It raises the table stakes of what customers expect, but it doesn’t allow a competitor to do anything that Adobe can’t do.
The file format network effects, industry standard, best-in-class suite of tools, brand name, and user habit are all things that a competitor will (and have) struggled to replicate. Canva may have taken huge share in the consumer market, but they are having trouble moving up and that is Adobe’s least profitable market anyway. By going down market with Adobe Express, they are limiting the risk of further share loss there (and if anything have a chance to regain some). Figma did carve out a large vertical in UI/UX from Adobe, but that threat seems now contained to just that market. AI models allow users to make images in a whole new way with chat boxes, but don’t allow them to granularly modify them in a way a professional editor would require. It doesn’t mean that Adobe is without risk—there are plenty—but in analyzing most of them, they are more like a tangential hit than a direct one. The kill shots to Adobe (one model superior to all others, AGI, one-shot perfect generation, AI models build their own high end editing tools) all seem like remote risks.
However, that doesn’t mean these risks can’t accumulate and ultimately lead to a weighing on growth. Customers spending more on AI features, which are costly for Adobe, could have real pressure on earnings growth. But for now, they have been able to maintain their margins just fine. In the future the cost of AI should also fall, which could mean it is easier for both Adobe and the AI models to make a margin. Different service providers incorporating generative AI features that reduces the need for a user to ever use photoshop is a real risk, but it is also more likely to pan out in the low end market. Having said all of that, many investors will still have a nagging feeling that AI must be disruptive to Adobe. Can it really be the case that they just trod along fine?
This is one of the rare businesses we have analyzed where the real hesitation comes from a pattern of confusing and seemingly discordant corporate actions. The odd CEO transition, ill explained successor choice, changes in reporting segments, and rare delayed price increases all suggest that something more is happening than we can see. But it is possible that the answer to all of these questions aren’t actually suggestive of deeper disruption, but just some fear in the face of fast moving AI.
Below we will go through what is priced in so an investor can better understand the assumptions they need to get comfortable with in order to see a return.
Valuation.
At a stock price of $245 and with LTM EPS at ~$18, Adobe trades at 13.6x earnings.
We re-ran our reverse DCF to see what was priced in below. You can see the revenue growth scenario assumptions and margin assumptions in the two tables below.
The outputs show that Adobe only needs to achieve 3% growth with flat margins for investors to get a ~11% return. (Remember the reverse DCF discounts all future cash flows and so it is a very long-term valuation). If an investor is more confident in Adobe’s ability to reaccelerate revenue growth to ~10% for the next 5 years and then fading thereafter, returns are closer to mid-teens.
It is up to each investor to decide whether they believe these returns compensate them for the assumptions they need to make.
*At the time of this writing, one or more contributors to this report may have a position in stocks mentioned. Furthermore, accounts one or more contributors advise on may also have a position in stocks mentioned. This may change without notice.