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Adobe Systems (ADBE) reported its third quarter fiscal year 2012 last week. It reported revenues of $1.081 billion for the period, within its revenue guidance of $1.075 billion to $1.125 billion. This translates to year-on-year growth of 6.7% but a decline of 3.8% on a quarter-on-quarter basis. The sequential decline in revenues is attributed to the adoption of new and lower priced subscription-based models from its clients. This translates to quarterly net income of $201.4 million, or equivalent to $0.40 per share for the period. This is higher than the previous year's net income of $195.1 million, or earnings per share of $0.39. On a quarter-on-quarter basis, this is also lower than the previous quarter's net income of $223.9 million, or earnings per share of $0.45.

Its digital media solutions segment generated 71.2% of revenue for the quarter. Segment revenue amounted to $769.1 million, down by 8.9% year-on-year but showed an increase of 3.1% year-on-year. Its sub-segment Document services performed a record quarter from continued Acrobat adoption from enterprise clients, as well as robust growth in other Acrobat related cloud services. It has added more than 100,000 net new subscriptions for the quarter, bringing the total paid subscriptions of 200,000 for the Creative Cloud software suite.

Meanwhile, its digital marketing accounted for 23.8% of the total third quarter revenue for the period. Revenues for the segment amounted to $257.1 million. This is up by 2.5% from the previous quarter but down by 18.5% compared to the same period last year.

Creative + Cloud Is Adobe's Formula for Future Growth

Looking at the recent quarter gives me an overview of Adobe's future growth. It seems that the bread and butter segment will still be Digital Media. As the company moves to subscription-based model, Creative Suite will provide a steady stream of monthly subscription revenues. This will even out the gyrations of software upgrade cycle. It must be noted that its creative software revenues slowed down in the prior quarter as customers hold off purchases from the launch of Creative Suite 6. The major updates included Photoshop, Premiere Pro, After Effects, In Design, Illustrator and Dreamweaver. Furthermore, it has recently launched Adobe Captivate 6, an upgraded version of the company's e-learning authoring software for creating interactive e-learning and HTML5-based mobile learning. It provides the users the ability to design interactive e-learning content. The strong competitive position of Adobe is the wide acceptance of most of its product in the market place. This easily keeps current and potential competitors at bay.

Adobe is following the lines of other companies such as SAP (SAP) and Oracle (ORCL). Oracle has also launched its New Application Software called Fusion Apps, recently. It has experienced strong gains from this segment, generating $2.7 billion for Oracle last year. It also currently added strong products to its current portfolio. It has acquired companies such as Peoplesoft, JD Edwards and Siebel Systems to beef up its future offerings to its clients.

On the other hand, SAP has also increased its focus on the mobile, cloud services and HANA businesses. The company is targeting revenues of $422 million from HANA and mobile revenues of $290 million. Moving forward, it plans to split its reporting its revenues from its cloud services. This implies that it will have significant contribution of its businesses in the future.

Adobe is also looking to launch several tablet apps for Apple (AAPL) iOS and Google's (GOOG) Android. This would likely lead to higher sales as the tablet industry will continue to post solid gains in the future. Meanwhile, its digital marketing will also be another focus for Adobe. For instance, it has acquired Efficient Frontier, a leader in the ad buying and optimization platform for Facebook (FB) and Google Adwords. Going forward, analysts expect this segment to contribute almost 25% of the company's revenues.

Adobe Competitive Advantage Evident in Its Financials

For the last 5 years, its revenues have grown by 13.11% a year. This translates to operating margins increasing from 24.6% in 2002 to 26.1% in 2011. This implies that the company's product suite has superiority over its competitors. Also, it commands pricing power allowing the company to maintain its margins. Its free cash flow has also increased from $298 million in 2002 to $1.33 billion in 2011. This translates to growth of 38.47% for the last 9 years.

Management sees revenues of $1.075 billion to $1.125 billion for the fourth quarter of this year. It sees lower digital media revenues from the integration of Creative Cloud. Its Digital Marketing is expected to grow sequentially. For the current fiscal year, Adobe is expected to earn $2.35 per share, flat from the previous year's figure. For the next 5 years, it is expected to grow by 10.67% a year.

Microsoft (MSFT) reported a 10% revenue growth for the same period. But, its operating margins have declined from 41.1% in 2003 to 29.5% in 2012. The decline in operating margin is due to the decline in the company's core products as it faces headwinds from the rise of mobile phones and tablets. Despite these negative headwinds, its free cash flow has increased from $14.90 billion in 2003 to $29.3 billion in 2011.

Another competitor SAP posted lower revenue growth. SAP has revenue growth of 6.85% for the last 10 years. This translates to operating loss of 78.1% in 2002 to 34.3% in 2011. Its free cash flow has also increased from $1.15 billion in 2002 to $3.4 billion. This yields to 28% growth for the period.

Adobe Should Be Valued As a Cloud Computing Stock

The stock trades at 13 times earnings and 2.7 times book. This is lower than its 5-year average earnings multiple of 27.1 times. It has a price to growth ratio (PEG) at 2.6 times.

At these levels, Adobe does not look cheap. Its competitors have lower valuations. Oracle is valued at 10.7 times earnings and has a PEG ratio of 1.2 times. Microsoft is valued at 9 times earnings and 3.9 times book. It also has a PEG ratio of 5.8 times. But, I believe that Adobe should be valued more as a cloud computing stock rather than a traditional technology company. Salesforce.com (CRM) is valued at 90 times earnings. The market is overly optimistic about the role of cloud computing in the future. This results in double digit earnings multiples moving forward.

I believe that Adobe is undervalued. Its board has approved buying back up to $2 billion by the end of 2015. I would recommend buying on dips. The market hates bad news. Disappointing earnings is an example. Investors can easily pick up Adobe shares every time it announces lower than expected financial results.

Source: Adobe: Buy This Undervalued Stock On Dips