Adobe Systems Inc. (ADBE) reported earnings for the first quarter ended February 2011 that was just slightly ahead of the Zacks Consensus estimate. Management stated that the situation in Japan put $50 million of revenue at risk, primarily in the CS and Acrobat product lines.
Revenues from other parts of the world are not likely to be impacted. Detailed commentary on the situation in Japan was not available, primarily because the exact impact is still hard to determine. This could be the reason that Adobe share prices lost 0.43% in after-hours trading, after climbing 1.67% during the day yesterday.
Revenue
Adobe’s total revenue was $1.03 billion, up 2.0% sequentially, 19.7% year over year and within management’s expectations of $1-1.05 billion (down 0.8% to up 4.2% sequentially). Revenue was more or less in line with the Zacks Consensus Estimate of $1.02 billion. Currency had a $5.9 million negative impact on year-over-year comparisons (there were no gains from the currency hedge program).
Products generated 82% of Adobe’s revenue, up 1.4% sequentially and up 19.7% year over year. The year-over-year increase in product revenue was primarily driven by the CS5 and Acrobat product lines. Subscription revenue comprised 10% of revenue, up 5.8% sequentially and up 11.2% from the year-ago quarter. Services & Support brought in the balance, representing sequential and year-over-year increases of 2.8% and 33.1%, respectively.
Revenue by Segment
The Creative Solutions segment, which remains Adobe’s largest, generated 41% of total quarterly revenue. Segment revenue was up 4.9% sequentially and 27.7% from last year. The CS5 poduct line continued to do well in the last quarter and a mid-cycle release has been slated for later this year.
The digital publishing suite (for creation, distribution, monetization and analysis of digital content) became broadly available during the quarter and Adobe stated that initial demand was strong all over the world. The segment now includes the Flash platform products, prospects for which are very bright according to Adobe.
Management quoted the Strategy Analytics forecast of a 132 million unit increase in smart phone shipments in 2011, 36% of which would support Adobe’s Flash Player. Flash penetration of smart phones and tablets has been growing over the last few months and video streaming through flash increased 100% in 2010, according to management.
Knowledge Worker revenues were up 7.0% sequentially and 9.6% year over year to 18% of total revenue. Adobe attributed the increase in the last quarter to both volume increases and price hikes. Entrprise adoption of the newly launched Acrobat 10 was one of the important drivers in the last quarter.
The Enterprise business brought in 10% of Adobe’s quarterly revenue, representing increases of 1.4% and 32.8% from the previous and year-ago quarters, respectively. Day Software content management products have been integrated within the segment and Adobe’s customers are increasingly buying its customer experience management philosophy.
Omniture generated nearly 11% of revenue in the last quarter, increasing 1.7% sequentially and 15.5% year over year. Adobe remains very upbeat about Omniture. And if Omniture’s transaction increase of 60 million and enterprise customer retention rate of 95% are anything to go by, the business certainly seems to be doing very well.
Revenue by Geography
Adobe’s business is fairly well diversified across geographies, although the Americas region remains the largest contributor to its revenues, with a revenue share of around 49%.
The EMEA region accounted for another 31% in the last quarter, with the balance coming from Asia. The Americas were up 2.2% sequentially, while the MEA was down 1.8%. Asia was much stronger, given that Japan is seasonally stronger in the months of February and March (February is included in the fiscal first quarter and March in the fiscal second quarter).
Adobe’s pro forma gross margin for the quarter was 91.1%, up 3 bps from 91.0% in the previous quarter and down 60 bps from 91.7% 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.
The product gross margin, at 96.4%, is the primary reason for Adobe’s high-margin profile, with both subscription (gross margin of 54.9% in the last quarter) and services & support (gross margin of 63.2%) generating significantly lower margins. In the last quarter, the product gross margin increased 59 bps sequentially, subscription increased 390 bps and services & support declined 700 bps. Subscription was the only category that grew from the year-ago quarter.
Adobe reported operating expenses of $607.5 million were 2.4% higher than the previous quarter’s $593.4 million. The operating margin of 32.0% was down 21 bps sequentially from 32.2%. The slight decline in operating margin may be attributed to higher R&D and engineering costs (as a percentage of sales) that was almost totally offset by flat to slightly lower cost of sales, S&M and G&A expenses (as a percentage of sales).
Net income
On a pro forma basis, Adobe generated a net income of $250.8 million, or a 24.4% net income margin compared to $249.2 million, or 24.7% in the previous quarter and net income of $164.4 million or 19.1% net income margin in the same quarter last year.
The fully diluted pro forma earnings per share (EPS) came in at 49 cents, similar to the November quarter and up from 36 cents in the quarter ended February 2010. Our pro forma estimate excludes restructuring charges, amortization of intangibles and investment gains and tax adjustments, but includes deferred stock compensation. Our pro forma calculations may differ from management’s presentation due to the inclusion/exclusion of any items that were not considered by management.
On a fully diluted GAAP basis, the company recorded a net loss of $234.6 million ($0.46 per share) compared to $268.9 million ($0.53 per share) in the previous quarter and $127.2 million ($0.24 per share) in the prior-year quarter.
Balance Sheet
Adobe ended with a cash and investments balance of $2.64 billion, up $168.8 million during the quarter. Cash and investments were nearly 32% of total assets at quarter-end. Cash generated from operations was $332.1 million. Principal uses of cash during the quarter included $36.6 million on acquisitions, $32.4 million on capex and $125.0 million on share repurchases.
At quarter-end, Adobe had $1.51 billion in long term debt, taking the net cash balance to $1.13 billion. Including long term liabilities, the debt-cap ratio was a mere 25.9%.
Guidance
Adobe provided guidance for the second quarter on both GAAP and non-GAAP basis.
Revenue is expected to come in at around $970 million to 1.02 billion (down 5.6% to 0.72% sequentially). The guidance excludes $50 million of revenue that Japan was expected to generate in next quarter. The mid-point of the guidance range assumes sequential growth in the Enterprise and Omniture businesses, with Creative Solutions, Knowledge Worker and Print & Publishing segments down slightly (impacted by Japan).
Beginning in the first quarter, the Creative Solutions segment was split into Digital Media Solutions and Creative and Interactive Solutions. Digital Media includes Adobe’s imaging and video-related products, while Creative and Interactive include the CS product lines, as well as the Platform segment, which is currently being reported as a separate segment.
The GAAP operating margin is expected to be 24.5-27.5%, non operating expense $16-20 million, tax rate 22%, share count 510-512 million, yielding GAAP EPS of 33-40 cents.
On a non-GAAP basis, operating margin is expected to be 34-36%, non operating expense $16-20 million, tax rate 22%, share count 510-512 million, yielding a non-GAAP EPS of 47-54 cents.
Our Recommendation
While we remain positive about Adobe’s market position, its compelling product lines, strong balance sheet and the end market recovery that should positively impact its results, Japan will be a slight negative this year and possibly next year as well. Management’s estimate of a $50 million top line impact indicates that approximately 5% of revenue is at risk.
We think the actual impact could be slightly higher, since Japan makes a more substantial contribution and the second quarter is usually a stronger quarter. Guidance looks conservative, even if we are to add back the estimated $50 million impact.
Additionally, Apple Inc (AAPL) continues to maintain its distance, promoting HTML 5 instead. As a result, the shares currently have a Zacks Rank of #4, implying a short-term Sell recommendation.
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