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Adobe Systems Inc. reported fourth quarter 2012 earnings of 49 cents per share, exceeding the Zacks Consensus Estimate of 46 cents. Adjusted earnings per share exclude one-time items but include stock-based compensation expense.

Revenue

Adobe’s total revenue was $1.153 billion, up 6.7% sequentially and 0.1% year over year. Reported revenue was also above the management’s expectation range of $1.075 billion to $1.125 billion. The increase was attributable to increased adoption of Adobe’s Creative Cloud and Adobe Marketing Cloud.

Products generated 74.0% of Adobe’s revenue, down 8.5% year over year. Subscription revenue comprised 17.0% of total revenue, up 51.5% sequentially and Services & Support brought in the balance, increasing 15.5% year over year.

Revenue by Segment

Digital Media Solutions, which remains Adobe’s largest, generated 70.3% of revenue in the quarter. Segment revenue was up 5.4% sequentially to $810.7 million. Within Digital Media, the two major components of revenue are Creative family of products and Document Services products.

Document Services (includes Acrobat family and new cloud-based services such as EchoSign) revenue was $210.2 million. 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.

At the end of fourth quarter, the adoption of Creative Cloud subscriptions continued to accelerate. The company added about 10,000 Creative Cloud subscriptions per week during the quarter versus 8,000 per week in the third quarter. In 2013, the company expects to offer Creative Cloud to enterprise customers.

Management was 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.

Digital Marketing segment accounted for 29.7% of total fourth quarter revenue. Within the segment, Adobe Marketing Cloud is the first component. It was earlier known as Digital Marketing Suite revenue and was up 32% from the year-ago quarter to $220.4 million, aided by increased demand for mobile devices. Mobile transactions increased to 22%, up from 18% in the last quarter.

The second component is revenue from the LiveCycle and Connect businesses, which was $70 million, down 31.8% from the year-ago quarter.

Margins

Reported gross margin for the quarter was 89.2%, down 70 bps from 89.9% 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 reported operating expenses of $720.7 million, which were 8.7% lower than the year-ago quarter’s $789.7 million. Operating margin was 26.7%, which was up from 21.4% in the year-ago quarter. As a percentage of sales, research and development expenses, and general and administrative expenses declined, while sales and marketing expenses increased slightly.

Net Income

On a GAAP basis, Adobe recorded a net income of $222.3 million (44 cents per share) compared with $173.7 million (35 cents per share) in the year-ago quarter.

On a pro forma basis, Adobe generated net income of $246.7 million compared with $270.6 million in the year-ago comparable quarter and 224.9 million in the previous quarter. Pro forma earnings per share came in at 49 cents compared with 55 cents in the year-ago quarter and 45 cents in the previous quarter.

Balance Sheet

Adobe ended the fourth quarter with cash and investments balance of $3.54 billion versus $3.25 billion in the previous quarter. Days sales outstanding (DSO) was 49 days versus 50 days in the year-ago quarter and 48 days in the last quarter. Deferred revenue was $58.1 million versus $560.3 million in the prior quarter.

In the fourth quarter, cash generated from operations was $473.3 million and capital expenditure was $81.8 million. The company also repurchased approximately 2.0 million shares at a total cost of $67 million.

Guidance

For the first quarter, management expects revenue in the range of $950 million to $1 billion. Additionally, management expects Digital Media segment to be down sequentially due to continued migration to Creative Cloud subscription and term-based Enterprise Term License Agreements (ETLAs) as well as normal seasonality.

In the Digital Marketing segment, management expects Adobe Marketing Cloud to be relatively flat sequentially, coupled with a decline in LiveCycle and Connect businesses.

Accordingly, based on a share count of 503–505 million, GAAP EPS is expected in the range of 8-14 cents, while non GAAP EPS is expected in the range of 26–32 cents. Currently, the Zacks Consensus Estimate for the upcoming quarter is pegged at 45 cents.

Also, for the first quarter, non-operating expense is expected in the range of $19–$21 million. Tax rate is expected to be approximately 28.0% on a GAAP basis and 22.5% on a non-GAAP basis.

For the full year 2013, the company expects adjusted earnings of about $1.40 per share on revenue of about $4.1 billion.

Our Recommendation

We find Adobe’s fourth quarter results impressive, as both earnings and revenues were above the prior year figures. Strong adoption of Creative Cloud and Adobe Marketing Cloud helped the results in the quarter.

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 over 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 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, end-market recovery appears slow and a weak demand environment in Europe remains a matter of concern. Additionally, the company faces strong competition from Apple Inc.  and Microsoft Corp. .

Currently, Adobe has a Zacks #4 Rank (Sell).

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