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Adobe Systems Inc. (ADBE - Analyst Report) reported first-quarter 2013 earnings of 22 cents per share, beating the Zacks Consensus Estimate of 20 cents. Adjusted earnings per share exclude one-time items but include stock-based compensation expense.

Revenues

Adobe’s total revenue was $1.008 billion, down 12.6% sequentially and 3.6% year over year. However, reported revenues were slightly above management’s expectation range of $950 million to $1.0 billion attributable to increased adoption of Adobe’s Creative Cloud.

Products generated 67.0% of Adobe’s revenues and were down 16.4% year over year. Subscription revenues comprised 22.0% of total revenue, up 53.4% sequentially and Services & Support brought in the balance, increasing 19.1% year over year.

Revenues by Segment

Digital Media Solutions, which remains Adobe’s largest, generated 68.3% of revenues in the quarter. Segment revenues were down 17.8% sequentially to $688.0 million. Within Digital Media, the two major components of revenues are the Creative family of products and Document Services products.

In the Creative business, the adoption of Creative Cloud subscriptions continued to accelerate. The company added approximately 153,000 net new paid subscriptions with Creative Cloud for individuals and teams offerings. As the end of the first quarter, 92% of Creative Cloud subscribers were on an annual plan versus month-to-month and 81% of subscribers licensed to the full Creative Cloud versus point product subscriptions. As announced earlier, the company continued to migrate enterprise customers to Enterprise Term License Agreements or 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 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. Adobe expects to reach 1.25 million paid subscriptions by the end of this year.

In the Document Services (includes Acrobat family and new cloud-based services such as EchoSign) business revenues were 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 31.7% 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 20% from the year-ago quarter to $215.0 million, aided by increased demand for mobile devices. Mobile transactions increased to 25% from 22% in the last quarter.

The second component, the LiveCycle and Connect businesses generated revenues of $52 million, in line with management expectations,

Margins

Reported gross margin for the quarter was 84.5%, down 510 bps from 89.6% in the comparable year-ago quarter. The gross margin is typical of a software company and variations are related to the mix of revenues between categories.

Adobe reported operating expenses of $740.5 million, which were 15.8% higher than the year-ago quarter’s $639.4 million. Consequently, operating margin of 9.7% was down from 27.7% 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 $65.1 million (13 cents per share) compared with $185.2 million (37 cents per share) in the year-ago quarter.

On a pro forma basis, Adobe generated net income of $110.1 million compared with $210.2 million in the year-ago comparable quarter. Pro forma earnings per share came in at 22 cents compared with 42 cents in the year-ago quarter.

Balance Sheet

Adobe ended the first quarter with cash and investments balance of $3.66 billion versus $3.54 billion in the previous quarter. Days sales outstanding (DSO) were 44 days versus 45 days in the year-ago quarter and 49 days in the last quarter. Deferred revenues increased $80.5 million to a record $700.0 million.

In the first quarter, cash generated from operations was $322.0 million and capital expenditure was $60.2 million. The company also repurchased approximately 2.7 million shares at a total cost of $100 million.

Guidance

For the second quarter, management expects revenues in the range of $975 million to $1.025 billion, up 110.5% 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 as well as normal seasonality.

In the Digital Marketing segment, management expects Adobe Marketing Cloud revenues to increase 20% year over year.

Accordingly, based on a share count of 507–509 million, GAAP earnings per share are expected in the range of 8–14 cents, while non-GAAP earnings per share is expected in the range of 29–35 cents. Currently, the Zacks Consensus Estimate for the upcoming quarter is pegged at 24 cents.

Also, for the second 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.

For the full year 2013, the company expects adjusted earnings of about $1.45 versus its prior guidance of $1.40 and above analysts' estimates of $1.41 per share. GAAP earnings per share is expected to be 62 cents per share.

Our Recommendation

We find Adobe’s first-quarter results decent with earnings exceeding the Zacks Consensus Estimate. Additionally, both revenues and earnings were above management expectations due to strong adoption of 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 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 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, end-market recovery appears slow and a weak demand environment in Europe remains a matter of concern.

Currently, Adobe has a Zacks Rank #3 (Hold). Other stocks in the sector that have been performing well and are worth a look include ACI Worldwide Inc. (ACIW - Snapshot Report), Advent Software Inc. (ADVS - Snapshot Report) and Pegasystems Inc. (PEGA - Snapshot Report), all carrying a Zacks Rank #1 (Strong Buy).

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