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Adobe Systems Earnings: Subscriptions Are Paying Off

Adobe Systems reported its third-quarter results on September 16, edging out analyst estimates for earnings, but falling slightly short on revenue. The company's shift to subscription-based products is progressing, with the number of subscribers rising sharply during the quarter. Both Adobe's creative and marketing subscription products grew strongly. Here's a look at Adobe's results.

Earnings summary

Analyst Expectation Actual Result
Revenue $1.02B $1.005B
EPS $0.26 $0.28

Source: Adobe and Yahoo Finance.

Adobe is transitioning from a traditional one-time software license model to a subscription-based model. During the quarter, growth in subscription revenue outpaced the decline in product revenue, leading to revenue growth of 0.5% year over year.

Revenue in millions USD YOY change % of total revenue
Product $349 (40%) 34.7%
Subscription $547 83% 54.4%
Services $109 (4%) 10.8%

Source: Adobe.

About 63% of Adobe's revenue during the quarter was derived from recurring sources. This number is set to grow as Adobe completely abandons product license sales in favor of a subscription-only business model. Adobe sells its creative products, such as Photoshop and Illustrator, as part of its Creative Cloud subscription product. It also sells its digital marketing and analytics tools as part of its Marketing Cloud subscription product.

The number of Creative Cloud subscriptions rose by 502,000 during the third quarter, bringing the total number of subscriptions to 2.81 million, an increase of more than 20% in just a single quarter. This is an acceleration compared to the second-fiscal quarter, when Adobe added 464,000 Creative Cloud subscriptions, and the first-fiscal quarter, when Adobe added 405,000 subscriptions. Adobe previously stated that it expects the total number of subscriptions to reach 3.3 million by the end of fiscal 2014.

Because revenue from subscriptions is recognized over the duration of the subscription as opposed to one-time software sales, where revenue is recognized at the time of the sale, Adobe's total revenue is well below peak levels from fiscal 2012. Adobe's deferred revenue, which is revenue that has not yet been recognized, has grown by 20% since the end of fiscal 2013.

Making progress, but expectations are too high

Adobe's shift to subscription products seems to be going well, with Creative Cloud growth accelerating in absolute terms during the third quarter. Moving to subscriptions has its benefits for Adobe, as it no longer has to convince customers to upgrade their software every few years. It also greatly lowers the cost of entry into Adobe's suite of products.

There is the risk that some customers shun Adobe and move to a competitor that still offers perpetual software licenses; but the bigger risk for investors is actually Adobe's valuation. Analysts expect full-year earnings to be just $1.23 per share this year, putting the P/E ratio based on that number at a staggering 57.5. Analysts expect earnings to grow to $2.10 per share in fiscal 2015, a tall order considering that Adobe's EPS before the transition to the cloud was just $1.66. Even using that optimistic number, the forward P/E ratio still works out to nearly 34.

Adobe's move to subscriptions certainly has the potential to pay off big for the company; but with valuations currently in the stratosphere, it's unlikely to pay off for investors buying at the current price.

The bottom line

Adobe is successfully executing its strategy, and the rapid growth in subscribers during the third quarter illustrates the success that the company is having moving customers over to subscription plans. The market, however, appears almost irrationally optimistic on Adobe's prospects, and it doesn't seem possible for Adobe to grow fast enough to justify its sky-high valuation. It was a good quarter for Adobe, but investors should carefully consider the valuation before investing in the company.

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The article Adobe Systems Earnings: Subscriptions Are Paying Off originally appeared on Fool.com.

Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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