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Adobe Systems Inc. (ADBE - Analyst Report) reported third-quarter 2013 earnings of 22 cents per share, slightly above 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 5.53% in after-hours trading.

Revenues

Adobe’s total revenue was $995.1 million, down 1.5% sequentially and 7.9% year over year. Reported revenues were at the lower end of management’s guided range of $975.0 million to $1.025 billion. The acquisition of Neolane contributed approximately $6 million of revenues in the quarter. The lower revenues indicate that the faster-than-expected shift to subscription pricing model is leading to more deferred revenues.

Products generated 58.5% of Adobe’s revenues but were down 28.2% year over year. Subscription comprised 30.1% of total revenue, up 73.1% year over year while Services & Support brought in the balance, increasing 16.9% year over year.


Revenues by Segment

Digital Media Solutions, which remains Adobe’s largest, generated 64.0% of revenues in the quarter. Segment revenues were down 4.9% sequentially to $637.0 million. The two major revenue earners within the segment are the Creative family of products and Document Services products.

In the Creative business, Creative Cloud subscriptions continued to accelerate. The company ended the third quarter with approximately 1031,000 paid subscriptions with Creative Cloud for individuals and teams, an increase of 331,000 in the quarter. At the end of the third quarter, 95% 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 earlier, 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 allow customers to access 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 $183.0 million, down 8.2% sequentially. The segment performed better-than-expected driven by continued Acrobat adoption in enterprise as well as continued momentum in EchoSign and other related Acrobat cloud services.

The Digital Marketing segment accounted for 26% 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 28% from the year-ago quarter to $255.0 million, aided by increased demand for mobile devices. Mobile transactions increased to 28% from 26% in the last quarter.

The second component, the LiveCycle and Connect businesses, generated revenues of $57.0 million, in line with management’s expectations.

Print and Publishing revenues were down sequentially.

Margins

Reported gross margin for the quarter was 85.2%, down 370 basis points (bps) from 88.9% 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 $737.7 million, up 8.1% from the year-ago quarter’s $682.7 million. As a result, operating margin plummeted to 11.1% from 25.8% 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.

Net Income

On a GAAP basis, Adobe recorded net income of $83.0 million (16 cents per share) compared with $201.4 million (40 cents per share) in the year-ago quarter.

On a pro forma basis, Adobe generated net income of $111.3 million compared with $224.9 million in the year-ago comparable quarter. Pro forma earnings per share came in at 22 cents compared with 45 cents in the year-ago quarter.

Balance Sheet

Adobe ended the third quarter with cash and investments balance of $3.16 billion versus $3.87 billion in the previous quarter. Days sales outstanding (DSO) were 48 days versus 48 days in the year-ago quarter and 42 days in the last quarter. Deferred revenues increased $44.2 million to $683.1 million.

In the third quarter, cash generated from operations was $215.5 million and capital expenditure was $46.8 million. Additionally, the company repurchased approximately 7 million shares for a total cost of $326 million in the quarter.

Guidance

For the fourth quarter, management expects revenues in the range of $1.0 billion to $1.050 billion, up 3% sequentially at the mid-point. The guidance includes $20 million of revenues from Neolane acquisition.

Additionally, management expects Digital Media to be down sequentially due to continued migration to Creative Cloud subscription and term-based ETLAs.

In Digital Marketing segment, management expects Adobe Marketing Cloud revenues to increase 35% year over year and LiveCycle and Connect revenues to be relatively flat sequentially. Print and Publishing revenues are expected to decline sequentially.

Accordingly, based on a share count of 511–513 million, GAAP earnings per share are expected in the range of 9 cents–15 cents, while non-GAAP earnings per share are expected in the range of 28 cents–34 cents.

Also, for the fourth quarter, non-operating expense is expected in the range of $17 million–$19 million and tax rate is expected to be approximately 21.0%.

Our Recommendation

We find Adobe’s third-quarter results decent with earnings exceeding the Zacks Consensus Estimate due to strong adoption of the Creative Cloud.

Management expects revenues to increase sequentially in the upcoming quarter, indicating market recovery. It expects strong ELTA adoption in the near term, further expanding its Creative Cloud business.

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 brings in 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 Neolane will further enhance its Adobe Marketing Cloud by integrating online and offline marketing data and accelerating its entry into social advertising.

Currently, Adobe has a Zacks Rank #2 (Buy). Other stocks that are performing well at current levels include SanDisk (SNDK - Analyst Report), Micron Tech. (MU - Analyst Report) and Silicom Ltd. , all carrying a Zacks Rank #1 (Strong Buy).
 

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