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Adobe Systems Inc. (ADBE - Analyst Report) reported second quarter 2013 earnings of 24 cents per share, beating the Zacks Consensus Estimate of 21 cents. Adjusted earnings per share exclude one-time items but include stock-based compensation expense. Following the earnings release, share price rose 5.21% in after-hours trading.
Adobe’s total revenue was $1.011 billion, up 0.3% sequentially but down 10.1% year over year. Reported revenues were within management’s guided range of $975.0 million to $1.025 billion. The sequential increase was attributable to increased adoption of Adobe’s Creative Cloud.
Products generated 64.0% of Adobe’s revenues but were down 26.0% year over year. Subscription comprised 25.0% of total revenue, up 59.6% year over year while Services & Support brought in the balance, increasing 18.3% year over year.
Revenues by Segment
Digital Media Solutions, which remains Adobe’s largest, generated 66.3% of revenues in the quarter. Segment revenues were down 2.6% sequentially to $670.0 million. Within Digital Media, the two major components of revenues are the Creative family of products and Document Services products.
In the Creative business, Creative Cloud subscriptions continued to accelerate. The company ended the second quarter with approximately 700,000 paid subscriptions with Creative Cloud for individuals and teams. At the end of the second quarter, 93% of Creative Cloud subscribers were on an annual plan versus the monthly plan and 81% of subscribers licensed to the full Creative Cloud versus point product subscriptions. As announced in the last quarter, the company started to convert enterprise customers to Enterprise Term License Agreements or ETLAs and saw increased adoption of its enterprise Creative Cloud offering through ETLAs. ETLAs for enterprise customers are term-based, and give customers access to ongoing technology updates and represent the first phase of migrating enterprise customers to Creative Cloud.
Management is quite optimistic about Creative Cloud adoption and expects to build a healthy pipeline for potential Creative Cloud paid subscribers through marketing programs, trial downloads and free memberships.
In the Document Services business (includes Acrobat family and new cloud-based services such as EchoSign), revenues were $199.3 million, up from the year-ago quarter. The segment had a record quarter, thanks to continued Acrobat adoption in enterprise as well as continued momentum in EchoSign and other related Acrobat cloud services.
The Digital Marketing segment accounted for 33.7% of total second quarter revenue. Within the segment, Adobe Marketing Cloud is the first component. Formerly known as Digital Marketing Suite, its revenues were up 17% from the year-ago quarter to $229.6 million, aided by increased demand for mobile devices. Mobile transactions increased to 26% from 25% in the last quarter.
The second component, the LiveCycle and Connect businesses generated revenues of $55.8 million, in line with management expectations.
Print and Publishing revenues were essentially flat sequentially.
Reported gross margin for the quarter was 86.6%, down 180 bps from 88.4% in the comparable year-ago quarter. The gross margin is typical of a software company and variations are generally related to the mix of revenues between categories.
Adobe incurred operating expenses of $726.2 million, up 7.1% from the year-ago quarter’s $678.0 million. As a result, operating margin plummeted to 11.0% from 27.1% in the year-ago quarter. As a percentage of sales, research and development expenses, general and administrative expenses as well as sales and marketing expenses increased from the year-ago quarter.
On a GAAP basis, Adobe recorded net income of $76.5 million (15 cents per share) compared with $223.9 million (45 cents per share) in the year-ago quarter.
On a pro forma basis, Adobe generated net income of $122.5 million compared with $245.7 million in the year-ago comparable quarter. Pro forma earnings per share came in at 24 cents compared with 49 cents in the year-ago quarter.
Adobe ended the second quarter with cash and investments balance of $3.87 billion versus $3.66 billion in the previous quarter. Days sales outstanding (DSO) were 42 days versus 43 days in the year-ago quarter and 44 days in the last quarter. Deferred revenues decreased $61.1 million to $638.9 million.
In the second quarter, cash generated from operations was $299.1 million and capital expenditure was $46.2 million. Additionally, the company repurchased approximately 3.9 million shares for a total cost of $172 million in the quarter.
For the third quarter, management expects revenues in the range of $975 million to $1.025 billion, down 1.1% sequentially at the mid-point. Additionally, management expects Digital Media to be down sequentially due to continued migration to Creative Cloud subscription and term-based ETLAs.
In the Digital Marketing segment, management expects Adobe Marketing Cloud revenues to increase 20% year over year. Within the Digital Marketing segment, management expects LiveCycle and Connect revenues to be relatively flat and Print and Publishing to decline sequentially.
Accordingly, based on a share count of 511–513 million, GAAP earnings per share are expected in the range of 10–16 cents, while non-GAAP earnings per share are expected in the range of 29–35 cents. Currently, the Zacks Consensus Estimate for the upcoming quarter is pegged at 22 cents.
Moreover, for the third quarter, non-operating expense is expected in the range of $17–$19 million. Tax rate is expected to be approximately 22.5% on a GAAP basis and 21.0% on a non-GAAP basis.
We find Adobe’s second quarter results decent with earnings exceeding the Zacks Consensus Estimate due to strong adoption of the Creative Cloud.
We remain positive about Adobe’s market position, its compelling product lines (including CS cloud initiative and digital media products), continued innovation and strong balance sheet. However, we believe that the new subscription service will hurt Adobe's financial growth, at least in the short term, as it generates revenues on a monthly basis instead of a lump sum at the start.
We believe that solid adoption of the Creative Cloud could serve as a potential catalyst going forward. Adobe’s acquisition of Efficient Frontier will further enhance its Adobe Marketing Cloud by adding optimization capabilities for search and display advertising while accelerating its entry into social advertising.
However, management expects revenues to decline sequentially, indicating slow-end market recovery. Also a weak demand environment in Europe remains a matter of concern.
Currently, Adobe has a Zacks Rank #5 (Strong Sell). Other stocks in the sector that have been performing well and are worth a look include Aspen Tech Inc. (AZPN - Snapshot Report), SAP AG (SAP - Analyst Report) and Pegasystems Inc. (PEGA - Snapshot Report), all carrying a Zacks Rank #1 (Strong Buy).