Clouds Parting for Adobe?

A company that misses consensus forecasts on sales, earnings and forward guidance can normally expect investors to pummel its share price. Not so Adobe Systems (NasdaqGS: ADBE), which reported its fiscal 2013 third quarter earnings last night.

Anyone with an Internet connection has likely used Adobe’s products. The company makes the free Adobe Reader, which lets you view documents in PDF format, but it also produces software for design professionals, including Photoshop (for enhancing images), InDesign (for printed page layout) Dreamweaver (web design) and Illustrator.

Here’s how the company’s latest numbers looked:

During the quarter, which ended August 30, Adobe’s revenue fell 7.9% from a year ago, to $995.1 million. Net income declined 58.8%, to $83.0 million, or $0.16 a share. Excluding unusual items, Adobe earned $0.32 a share, down from $0.58. The latest results missed the consensus forecast of $0.34 a share in earnings on $1.01 billion of revenue.

The response? Investors bid up the shares by nearly 6% in after-hours trading, to $51.00, well above the all-time high of $48.70 they hit on Monday. Year-to-date, the stock is up 34.5%.

Adobe: A Tech Stock in Transition

To understand this inverse reaction, you have to go back a little more than a year, to April 2012, when the company launched Creative Cloud, which involves selling its Creative Suite of programs, including Photoshop, Illustrator, InDesign, Dreamweaver and others, on a subscription basis instead of a one-time license.

In May 2013, the company took it a step further, announcing that it would no longer sell packaged software after Creative Suite 6.0. That was a bold move: many other software makers, such as Microsoft (NasdaqGS: MSFT) have cloud offerings, but most still offer packaged and downloadable versions, as well.

Focusing on the cloud has a number of advantages. For consumers, switching to a subscription model provides flexibility and makes budgeting easier: with an annual contract, users get full access to Adobe’s creative software for just $49.99 a month instead of one-time costs of $700 to $2,500. Users can subscribe to just one application for $19.99 a month.

For its part, Adobe will see its revenue even out instead of spiking around new product launches. It also helps the company compete with free software available on the Internet.

However, the changeover does weigh on the company’s sales, as it is now paid in monthly installments instead of all at once. It is also increasing Adobe’s near-term costs.

Switch Looks Ahead of Schedule

Which brings us back to last night’s earnings release. Adobe announced that it had added 331,000 new Creative Cloud subscribers in the quarter, bringing the total just over a million. That was ahead of many analysts’ expectations and marks a continued acceleration from the 221,000 it added in the second quarter and 153,000 in the first quarter.

“It’s all subscriber related,” said UBS analyst Brent Thill, who has a buy rating on the shares, in a Bloomberg article, “The near-term revenue is taking a co-pilot seat. It’s all about the value of those subscribers over time.”

The gains put the company in reach of its goal of 1.25 million subscribers at the end of the first year. But 2015, it aims to have four million.

Adobe also reported a stronger-than-expected uptake among business users. In the post-earnings conference call, CFO Mark Garrett said the company closed more contracts with corporate clients in the third quarter than in the entire first half.

Nearly Half of Adobe’s Revenue Is Now Recurring

As you’d expect, Adobe’s subscription revenue surged 73.1% from a year ago, to $299.3 million. Product sales declined 28.2%, to $582.2 million. Services and support revenue gained 16.9%, to $113.6 million.

The company’s revenue mix gives a good snapshot of how far its transition has come: recurring revenue now accounts for 41% of the total. The switch to subscriptions increased deferred revenue by $42.7 million, to a record $734.0 million.

Operating costs rose 8.0% from a year ago, to $737.7 million, which was better than the previous quarter’s 11.0% year-over-year increase and the 16.9% rise seen in the first quarter. Operating margin came in at 11.1%, down from 25.8% a year ago but up slightly from 11.0% in the second quarter.

The company is also seeing strong growth at its Marketing Cloud business, a set of analytical tools for measuring the effectiveness of marketing campaigns. Without the contribution from France-based Neolane, which Adobe bought for $600 million in cash in June, Marketing Cloud revenue rose 25% from a year ago. Including Neolane, revenue gained 28%.

Neolane helps businesses manage marketing campaigns across a range of channels, including the Internet, social media, mobile, call center, direct mail and point of sale. Newly renamed Adobe Campaign, the company will become the sixth offering in the marketing cloud.

Adobe forecasts revenue of $1 billion to $1.05 billion for the fourth quarter, and earnings (excluding items) of $0.28 to $0.34 a share. That was below the Street’s estimate of $0.41 a share in profits on $1.08 billion of revenue.

Both estimates are well below the $0.61 a share that Adobe reported in the same quarter a year ago, so investors hoping for a return to year-over-year earnings growth will have to remain patient, but the company said it expects to add more Creative Cloud subscribers in the fourth quarter than in the third, driven by an increase in corporate agreements.

Meantime, Adobe’s balance sheet strength gives it plenty of flexibility to continue its transition and make further acquisitions: it ended the quarter with cash and short-term investments of $3.2 billion. That’s down from $3.9 billion at the end of the second quarter (before the Neolane purchase), but it’s still more than double Adobe’s $1.5 billion of debt.