Adobe Systems Inc. (ADBE) reported earnings for the fourth quarter ended November 2010 that beat the Zacks Consensus Estimate by 5 cents. The company’s results reflect the gradual turnaround in the broader commercial and enterprise markets.
Revenue
Adobe’s total revenue was $1.01 billion, up 1.8% sequentially, 33.1% year over year and just over management’s own expectations of $950 million to $1 billion. Revenue also exceeded the Zacks Consensus Estimate of $988 million by 2.0%. Currency had a $7.4 million ($6.7 million excluding currency hedge) negative impact on year-over-year comparisons.
Products generated 82% of Adobe’s revenue, flat sequentially and up 23.9% 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 1.8% sequentially and up 172.2% from the year-ago quarter. Services & Support brought in the balance, representing sequential and year-over-year increases of 22.5% and 53.4%, respectively.
Revenue by Segment
The Creative Solutions segment, by far Adobe’s largest, generated 54% of total quarterly revenue. Segment revenue was down 1.4% sequentially, while increasing 26.3% from last year.
Favorable comps aside, the year-over-year increase was helped by the launch of Photoshop Elements products, which led to progressively stronger demand through the quarter. Adobe also mentioned several large licensing contracts that were closed during the quarter.
Knowledge Worker revenues were up 4.5% sequentially and 13.8% year over year to 17% of total revenue. Adobe expressed excitement regarding the segment, attributing the increase from the year-ago quarter to continued success of Acrobat 9 as well as the newly launched Acrobat 10. Enterprise adoption of Acrobat volume licensing remains phenomenal, according to management.
The Enterprise business was very strong, generating 10% of Adobe’s quarterly revenue, signifying increases of 10.6% and 66.7% from the previous and year-ago quarters, respectively. The recently acquired Day Software contributed $5.4 million, but was obviously not the sole reason for the increase. The core business did extremely well, helped partly by the improving commercial climate and stronger government spending, we think.
Omniture also generated 10% of revenue, increasing 8.1% sequentially. Adobe has now completed a full year with Omniture in its ranks and management was very upbeat about the success of the combined operations. And if Omniture’s enterprise customer retention rate of 95% is 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 nearly 49%. The EMEA region accounted for another 32% in the last quarter, with the balance coming from Asia.
Revenues from EMEA were up 11.6% sequentially, while those from the Americas and Asia were down 1.9% and 3.2% sequentially. Adobe stated that demand was strong in the EMEA and stable in the Americas and Asia.
The pro forma gross margin for the quarter was 91.0%, down 70 bps from 91.7% in the previous quarter and 55 bps from 91.6% in the comparable quarter of 2009. Variations in gross margin are generally related to the mix of revenues between categories.
The product gross margin, at 95.8%, is the primary reason for Adobe’s high-margin profile, with both subscription (gross margin of 51.0% in the last quarter) and services & support (gross margin of 70.2%) generating significantly lower margins. However, while the product gross margin saw a 72 bp sequential decline, subscription and services & support expanded 219 bps and 125 bps, respectively. All categories witnessed very strong increases from the year-ago quarter, due to easier comps/higher volumes.
The Creative Solutions segment generated a gross margin of 94.0%, down 84 bps sequentially, Knowledge Worker 96.7% (down 26 bps), Enterprise 82.0% (down 368 bps), Platform 94.4% (down 13 bps) and Print and Publishing 93.7% (down 11 bps). Omniture was the only segment with sequential margin expansion. The segment generated a gross margin of 54.7%, which was up 598 bps.
The operating expenses of $593.4 million were 3.4% higher than the previous quarter’s $573.7 million. The operating margin of 32.2% was down 165 bps sequentially from 33.8%. The main reason for the weakness was higher S&M expenses (as a percentage of sales), although the weaker gross margin also contributed. R&D and G&A were down slightly as a percentage of sales.
Net income
On a pro forma basis, Adobe generated a net income of $249.2 million, or a 24.7% net income margin compared to $250.1 million, or 25.2% in the previous quarter and net income of $165.1 million or 21.8% net income margin in the same quarter last year. The fully diluted pro forma earnings per share (EPS) came in at 49 cents, compared to 48 cents in the August quarter and 31 cents in the November quarter of 2009.
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 $268.9 million ($0.53 per share) compared to $230.1 million ($0.44 per share) in the previous quarter and loss of $32.0 million ($0.06 per share) in the prior-year quarter.
Balance Sheet
Adobe ended with a cash and investments balance of $2.47 billion, down $110.3 million during the quarter. Cash and investments were 30% of total assets at quarter-end. Cash generated from operations was $310.6 million. Principal uses of cash during the quarter included $193.3 million on acquisitions, $55.4 million on capex and $200.0 million on share repurchases.
At quarter-end, Adobe had $1.51 billion in long term debt, taking the net cash balance to $954.4 million. Including long-term liabilities, the debt-cap ratio was a mere 26.6%.
Guidance
Adobe provided guidance for the first quarter on both GAAP and non-GAAP basis.
Revenue is expected to come in at around $1-1.05 billion (down 0.8% to up 4.2% sequentially). The mid-point of the guidance range assumes sequential growth in the Enterprise and Omniture businesses, with Creative Solutions and Knowledge Worker segments flat to slightly up and Platform and Print & Publishing down slightly.
The Creative Solutions segment will be split into Digital Media Solutions and Creative and Interactive Solutions. Digital Media will include Adobe’s imaging and video-related products, while Creative and Interactive will 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 28-29.5%, non-operating expense $16-20 million, tax rate 15%, share count 508-510 million, yielding GAAP EPS of 43-49 cents.
On a non-GAAP basis, operating margin is expected to be 37-38%, non-operating expense $16-20 million, tax rate 22%, share count 508-510 million, yielding a non-GAAP EPS of 54-59 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. We are also encouraged by the improving demand trends in Europe.
Despite these positives and notwithstanding the support from developers, we note that Apple Inc (AAPL) continues to maintain its distance, promoting HTML 5 instead. This could bear watching, as Apple continues to grow in leaps and bounds. The shares currently have a Zacks #3 Rank, implying a short-term Hold recommendation.
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