Adobe: Fresh High As Successful Transition Continues

| About: Adobe Systems (ADBE)

Shares of Adobe Systems (NASDAQ:ADBE) spiked upwards in after-hours trading on Tuesday. The market continues to applaud the company's bold move to change its subscription-based model which leads to short-term pain but should result in more stable operational returns in the long run.

Even when factoring in a solid transition, I think shares are valued a bit too high based on my estimates for two or three year's time.

I remain on the sidelines with a slightly bearish stance.

Third Quarter Results

Adobe generated third quarter revenues of $995.1 million, down 7.9% compared to a year earlier. Reported revenues came within Adobe's guided $975 to $1.025 billion in revenues, but fell short of consensus estimates of $1.01 billion.

Net earnings fell by 59% to $83.0 million as diluted earnings per share fell from $0.40 per share to $0.16 per share.

Non-GAAP earnings came in at $164.4 million, or $0.32 per share, missing consensus estimates of $0.34 per share.

Looking Into The Results

Adobe's revenues just missed the $1 billion mark for the quarter during which the acquisition of Neolane added $6 million in revenues.

As is well known, Adobe is transforming its business model toward a subscription-based revenue model.

Subscription revenues rose by 73.1% to $299.3 million, now making up 30% of total revenues. Product revenues fell by 27.2% to $582.2 million. Services and support revenues were up by 16.9% to $113.6 million.

Gross margins fell by 370 basis points to 85.2% of total revenues, while operating expenses increased by almost a full ten percent points to 74.1% of total revenues. All in all, this severely impacted operating earnings which fell from $278.3 million to $110.4 million.

And The Outlook

Adobe sees first quarter revenues coming in between $1.00 and $1.05 billion, which includes a $20 million contribution from Neolane. This implies that revenues are set to fall by 11.1% at the midpoint of the range compared to a year ago.

Fourth quarter non-GAAP earnings are seen between $0.28 and $0.34 per share, while GAAP earnings are expected to come in between $0.09 and $0.15 per share.

The full-year guidance will be released at the presentation of fourth quarter results.

On average, analysts were looking for fourth quarter non-GAAP earnings of $0.41 per share on revenues of $1.08 billion.


Adobe ended the third quarter with $3.16 billion in cash, equivalents and short-term investments. The company operates with $1.52 billion in total debt and capital lease obligations for a net cash position of $1.64 billion.

For the first nine months of the year, Adobe generated revenues of $3.01 billion, down 7.3% on the year before. Net earnings fell by 63% to $224.7 million. Given the fourth quarter guidance, annual revenues should come in just above $4.0 billion, while earnings are expected to fall below $300 million this year.

Factoring in gains of 5% in after-hours trading, with shares exchanging hands at $50 per share, the market values Adobe at some $25.3 billion. This values operating assets of the firm at $23.7 billion. Based on 2013's expected results, assets are valued at 5.9 times annual revenues and roughly 80 times GAAP earnings.

Adobe does not pay a dividend at the moment.

Some Historical Perspective

Shares of Adobe have risen from levels around $20 in 2003 to their mid forties by 2007. Shares have fallen back to lows of $20 in 2009, but have recovered to fresh highs around $50 per share at the moment.

In recent years, Adobe has seen strong revenue growth. Annual revenues have increased by some 50% in the three years leading up to 2012. Net earnings doubled to $833 million in the meantime. Given the results so far this year, and the outlook for the final quarter, both revenues and earnings are set to decline markedly in 2013 on the back of the changed business model.

Investment Thesis

It has taken some courage, not to mention short-term pain, but the change in the business model which Adobe is undergoing at the moment seems to pay off.

The shift to a subscription-based model is ahead of schedule, as deferred revenues keep increasing, making the company's operations much easier to predict going forward.

The vast majority of Adobe's customers are moving toward term-based licenses, demonstrating the success of the new offerings. The company now has 1.03 million Creative Cloud users which includes Photoshop, Illustrator and Dreamweaver, marking net additions of 331,000 customers over the quarter. As such, the full-year target of 1.25 million should be easily attainable. Note that Adobe has "millions" more in the pipeline which are currently on trial versions. Other good news is that Adobe sees comparatively low churn rates when trial versions run out, as many users switch to paid versions.

The company remains committed to its long-term targets. For 2015, the company targets 4 million subscribers for Creative solutions, and it sees compounded annual growth rates of 15% from 2014 to 2016.

Back in June, I last took a look at Adobe's prospects. I concluded that the valuation remains an issue with the business model in transition.

Adobe is confident, and the current results seem to indicate that the subscription model will smoothen results. This is already witnessed in lower seasonality between the third and fourth quarter. Better insight into future smoothened revenue and earnings streams should create more value for shareholders. The pace of user additions for creative solutions increased from 221,000 net additions in the second quarter to 331,000 over the past quarter.

For now, the prospects into 2014 look solid as more and more users will move from trial versions to actual product licenses which will boost the user base as well as average revenues per user.

Projecting recent growth, with exception of the past transition year, should create a steadily growing software company with large assets in the cloud. Adobe should be able to generate $5 billion in annual revenues on which it should be able to earn $1 billion going forward, let's say in two year's time, or so.

Yet there is still some work ahead, as the market sends shares to fresh highs which values the company at around 5 times revenues and 25 times earnings. While the strategic move is right, and should be applauded, I think the current valuation is a bit high.

To reiterate my stance, I remain on the sidelines, with a slight bearish stance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.