Adobe Beats, But Shares Slide - Analyst Blog

Revenue

Total revenue was $943.0 million, up 9.8% sequentially and 33.8% year over year, exceeding management's own expectations of around $875-925 million, or an increase of 1.9% to 7.7% sequentially. An extra week of operations in the fiscal first quarter added an additional $35 million to revenue.

Products generated 84% of revenue, increasing 13.0% sequentially and 22.7% 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, down 3.4% sequentially and up 664.5% from the year-ago quarter. Services & Support brought in the balance, representing a sequential decline of 6.3% and a year-over-year increase of 24.4%.

Product gross margin came in at 95.0% (down 165 basis points sequentially and up 237 bps year over year). This was followed by the Services and Support gross margin at 67.6% (up 153 bps sequentially and 399 bps year over year). Subscription revenue currently brings in the lowest gross margin at 45.6% (down 650 bps sequentially and up 1255 bps from the year-ago quarter). The year-over-year expansion in the gross margin across categories was the result of much higher revenue in the last quarter compared to the recession-hit year-ago quarter.

Revenue by Segment

The single largest driver of the sequential increase in revenue was the CS platforms, particularly CS4 and pent-up demand for CS5 across all geographic segments, which pushed up Creative Solutions revenue. As a result, Creative Solutions grew 23.3% sequentially to 56% of total revenue.

The other segment that witnessed a sequential increase was Print and Publishing, which at 5% of revenue, saw a sequential increase of 4.5%.

Knowledge Worker, Omniture and Enterprise brought in 17%, 9% and 8%, respectively. However, they all witnessed sequential declines. However, except for the Knowledge Worker segment (which was flat), all increased from the year-ago quarter. The Omniture enterprise customer retention rate remained strong at 93%, although it was slightly down from the 95% reported in the previous quarter.

Revenue by Geography

Although Asia remains the smallest contributor at just 22% of revenue, it witnessed the strongest growth at over 20%. The largest geography remains the Americas, which generated 48% of revenue and grew 11.5% sequentially. The EMEA region accounted for the balance and grew less than 1%. However, management stated that the debt crisis in Europe did not impact Adobe in the last quarter.

Margins

The pro forma gross margin for the quarter was 90.5%, down 120 bps from 91.7% in the Feb 2010 quarter and 134 bps from 91.8% in the May quarter of 2009. The sequential decline is related to gross margin declines in products and subscription revenue, stemming from margin contraction across all segments except Enterprise.

The Creative Solutions segment generated a gross margin of 93.1%, down 165 bps sequentially, Knowledge Worker 96.7% (down 50 bps), Enterprise 81.6% (up 64 bps), Platform 93.6% (down 167 bps). Print and Publishing 94.3% (down 38 bps) and Omniture generated 44.9%, down 709 bps. The addition of Omniture has lowered Adobe's margin profile, due to the difference in its business model.

The operating expenses of $578.2 million were 2.8% lower than the previous quarter's $562.7 million. The operating margin was 29.1%, up 301 bps sequentially from 26.1%. The main reason for the increase was lower R&D expenses, which declined as a percentage of sales. This was helped by lower G&A and flattish S&M, which more than offset the increase in COGS (as a percentage of sales).

Net income

On a pro forma basis, ADBE generated net income of $190.5 million, or a 20.2% net income margin, compared to $164.4 million, or 19.1% in the previous quarter and net income of $141.7 million or 20.1% net income margin in the same quarter last year.

Fully diluted pro forma earnings per share (EPS) came in at 36 cents, compared to 31 cents in the Feb quarter and 27 cents in the year-ago quarter. Our pro forma estimate excludes restructuring charges, amortization of intangibles and investment losses on a tax-adjusted basis, but includes deferred stock compensation. Our pro forma calculations may differ from management's presentation due to the inclusion/exclusion of some items that were not considered by management.

On a fully diluted GAAP basis, the company recorded a net loss of $148.6 million ($0.28 per share) compared to $127.2 million ($0.24 per share) in the previous quarter and $126.1 million ($0.24 per share) in the prior-year quarter.

Balance Sheet

The company ended with a cash and investments balance of $2.64 billion, down $27.6 million during the quarter. Cash and investments were 33% of total assets at quarter-end. Cash generated from operations was $251 million. Principal uses of cash during the quarter included $250 million on share repurchases and $50 million on capex.

At quarter-end, Adobe had $1.49 billion in long term debt, amounting to a net cash balance of $1.15 billion. Including long term liabilities, the debt-cap ratio was a mere 26.4%.

Guidance

Management provided guidance for the first quarter on both GAAP and non-GAAP basis.

Revenue is expected to come in at around $950 million to $1 billion (up 0.7% to 6.0% sequentially), excluding $5 million deferred Omniture revenue. The mid-point of the guidance range assumes slight growth in the Creative Solutions segment, along with growth in the Enterprise and Omniture businesses. The other businesses are expected to stay relatively flat sequentially.

The GAAP operating margin is expected to be 25.5%-27.5%, non operating expense $12.5-13.5 million, tax rate 25%, share count 532-534 million, yielding GAAP EPS of $0.32-$0.37.

On a non-GAAP basis, operating margin is expected to be 36% - 37%, non operating expense $12.5-13.5 million, tax rate 25%, share count 532-534 million, yielding a non-GAAP EPS of $0.46-$0.50.

Our Recommendation

While we remain positive about Adobe's market position, its compelling product lines and strong balance sheet, we expect the currency headwind in Europe to keep pressure on shares. This is the main reason for the Zacks #4 Rank (short term Sell) and longer term Neutral recommendation on the shares.