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Software manufacturer Adobe Systems (ADBE), best known for its industry-standard Creative Suite software, rallied last week after the company reported fourth quarter earnings which topped analysts' estimates on both top and bottom lines. Adobe reported earnings of 44 cents per share, or $222.3 million, on revenue of $1.15 billion. This constituted a 28% increase in EPS and 0.1% rise in revenue from the prior year quarter. Excluding one-time charges from stock-based compensation and restructuring charges, Adobe earned 61 cents per share, a 10% decrease from the previous year's 67 cents on the same basis.

Both Adobe's earnings and revenue topped its own prior estimate of 53 cents to 58 cents per share, on revenue between $1.08 billion and $1.13 billion. Adobe attributed its robust earnings to a successful transition to cloud-based software suites, increased demand for its digital marketing software, as well as a 6.8% decrease in overhead expenses.

The Creative Cloud

Adobe began transitioning its traditional packaged Creative Suite software - which includes its flagship Photoshop and Illustrator software - into a cloud-based subscription service last year, after the company reported several sequential quarters of lower revenue and earnings growth. The costly initiative, which caused a $94 million restructuring charge last quarter, has been decidedly successful, adding an average of 10,000 new subscribers weekly throughout the fourth quarter - a 25% improvement over the third quarter. Adobe managed to attract many new users with a free trial period for its Creative Suite products. 325,000 of these trial users converted to paid subscriptions, most of which are annual contracts.

During a conference call, CEO Shantanu Narayen was upbeat regarding the progress of moving Adobe's software to the cloud. "I think people are really seeing the benefits of always having access to the latest applications," he stated. "The new products we're delivering as part of the cloud are seeing significant adoption, which I think bodes well for us."

While offering its Creative Suite software "as a service" over the cloud presents casual and professional users with more flexible pricing options and instant updates, it runs a slight risk of cannibalization. Analysts have noted that a license for Adobe's traditional packaged Creative Suite software costs $780, while an annual cloud-based license costs $480. Adobe must keep cloud-based customers for two years or more to achieve higher profitability than its original product. Adobe's CFO Mark Garrett has accounted for this initial dip, lowering the company's fiscal 2013 guidance from $4.4 billion to $4.1 billion. However, he assured investors that this initiatives, though costly at first and slow to become earnings accretive, will be strongly profitable in the long run. "We get through that in 2013 and 2014 and beyond," stated Garrett, "the build-up in subscriptions will offset the decline in license revenue."

The Marketing Cloud

In addition to its cloud-based Creative Suite software, Adobe recently introduced digital marketing services, which offer data mining services to help businesses measure purchases, page views and traffic from social media sites. In the past year, these services - which Adobe calls the Marketing Cloud - have risen in popularity, helping businesses streamline marketing initiatives and alter their products for targeted demographics. Narayen noted that "there's no question that we're seeing quite a bit of synergy between the Creative Cloud and the Marketing Cloud," and has told investors that customers from one segment are likely to purchase products and licenses from the other one, which boost Adobe's revenue growth on both fronts.

Shares of Adobe have risen 40% over the past twelve months, outperforming the tech sector by a wide margin. The stock trades at 15.8 times forward earnings with a 5-year PEG ratio of 1.46, and does not pay a dividend.

Source: Adobe's Cloud-Based Initiatives Lift It Skyward