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Adobe Systems Inc. (ADBE - Analyst Report) reported first-quarter 2014 earnings of 16 cents per share, exceeding the Zacks Consensus Estimate by 4 cents. Adjusted earnings per share exclude one-time items but include stock-based compensation expense.

Revenues

Adobe reported revenues of $1.0 billion, down 4.0% sequentially and 0.8% year over year. Reported revenues were at the higher end of management’s guided range of $950.0 million to $1.0 billion and above the Zacks Consensus Estimate of $971.0 million driven by accelerated adoption of creative cloud subscription pricing model.

Products generated 47.1% of Adobe’s revenues but were down 30.2% year over year. Subscription comprised 42.4% of total revenue, up 88.9% year over year while Services & Support brought in the balance, down 2.5% year over year.

Revenues by Segment

Digital Media Solutions, Adobe’s largest segment, generated 64.1% of the revenues in the quarter. Segment revenues were up 1.6% sequentially to $641.0 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 first quarter with approximately 1844,000 paid subscriptions with Creative Cloud for individuals and teams, an increase of 405K in the quarter.

As announced earlier, the company started to convert enterprise customers to Enterprise Term License Agreements or ETLAs which led to 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.

The increased subscription and ETLA adoption helped to drive creative annualized recurring revenues or ARR to a total of $987.0 million, up $186.0 million sequentially.

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 $194.0 million, down 2.0% sequentially. The segment performed well driven by continued Acrobat adoption in enterprise as well as continued momentum in EchoSign and other related Acrobat cloud services. ARR in Document Services business grew to $164 million, up 14.7% sequentially.

The Digital Marketing segment accounted for 31.3% of total first-quarter revenue. Within the segment, Adobe Marketing Cloud is the first component. Formerly known as Digital Marketing Suite, its revenues were up 24% from the year-ago quarter to $267.0 million, aided by increased demand for mobile devices. Mobile transactions increased to 36% from 33% in the last quarter.

The second component, LiveCycle and Connect businesses, generated revenues of $47.0 million in the reported quarter. Management expects LiveCycle revenues to decline further, but Connect revenues to remain relatively flat in the upcoming quarter.

Print and Publishing revenues were $45.0 million in the last quarter.

Margins

Reported gross margin for the quarter was 85.2%, up 70 basis points from 84.5% 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 $772.9 million, up 2.6% from the year-ago quarter’s $753.0 million. As a percentage of sales, research and development, general and administrative as well as sales and marketing expenses increased from the year-ago quarter. As a result, operating margin plummeted to 7.9% from 9.7% in the year-ago quarter.

Net Income

On a GAAP basis, Adobe recorded net income of $47.0 million (9 cents per share) compared with $65.1 million (13 cents) in the year-ago quarter.

On a pro-forma basis, Adobe generated net income of $82.6 million compared with $110.1 million in the year-ago quarter. Pro-forma earnings came in at 16 cents per share compared with 22 cents in the year-ago quarter.

Balance Sheet

Adobe ended the quarter with cash and investments balance of $3.13 billion versus $3.17 billion in the previous quarter. Days sales outstanding (DSO) were 46 days versus 44 days in the year-ago quarter and 52 days in the last quarter. Deferred revenues increased $55.6 million to $831.1 million.

In the first quarter, cash generated from operations was $251.7 million and capital expenditure was $29.4 million. Additionally, the company repurchased approximately 4.5 million shares for a total cost of $263.0 million.

Guidance

For the second quarter, management expects revenues in the range of $1.0 billion to $1.05 billion, up 2.5% sequentially at the mid-point. Additionally, management expects total Digital Media to improve sequentially.

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

Accordingly, based on a share count of 508–510 million, GAAP earnings are expected in the range of 6–12 cents per share, while non-GAAP earnings are expected in the range of 26–32 cents per share. Analysts polled by Zacks expect non-GAAP earnings of 12 cents, well below the mid-point of the guided range. 

Also, for the second quarter, non-operating expense is expected in the range of $16–$18 million and tax rate is expected to be approximately in the range of 28–29% on a GAAP basis and 21% on a non-GAAP basis.

For fiscal 2014, Adobe maintains its total revenue guidance to be flat year over year. GAAP earnings are expected to be 27 cents per share and non-GAAP earnings to be $1.10 per share.

Our Recommendation

We find Adobe’s first-quarter results decent with earnings and revenues exceeding the Zacks Consensus Estimate. Management expects revenues to increase sequentially in the upcoming quarter 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.

Also, we believe 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 better-ranked stocks that are performing well at current levels include Dealertrack Technologies (TRAK - Snapshot Report), Open Text Corporation (OTEX - Snapshot Report) and Pegasystems (PEGA - Snapshot Report). All these stocks sport a Zacks Rank #1 (Strong Buy).

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