Adobe Systems Inc. (ADBE - Analyst Report) reported third-quarter fiscal 2016 earnings of 60 cents per share, which beat the Zacks Consensus Estimate by a couple of cents. Adjusted earnings per share exclude one-time items but include stock-based compensation expense.

Following strong fiscal third-quarter earnings and solid fourth-quarter guidance, the share price climbed more than 5% in after-hours trading session.

Better-than-expected earnings were backed by the strong adoption of cloud that led to robust Creative and Marketing Cloud revenues and better-than-expected Digital Media revenues.

Revenues

Adobe’s revenues of $1.46 billion increased 4.7% sequentially and 20.4% year over year. Reported revenues were on the higher end of management’s guided range of $1.420–$1.470 billion and above the Zacks Consensus Estimate of $1.453 billion.

Subscription comprised 80% of Adobe’s total third-quarter revenues, up 41.0% from the year-ago period. Products declined 34.3% year over year and contributed 12% to revenues, while Services & Support saw a 0.9% improvement and brought in the rest.

Revenues by Segment

Revenues from Digital Media Solutions segment jumped 29% year over year to $990 million. Total Digital Media ARR (Annualized Recurring Revenue) grew to $3.7 billion at the end of the fiscal third quarter, reflecting an increase of $285 million and pointing to strong growth in the Creative Cloud and Document Cloud businesses.

The two major revenue contributors within the segment were Creative Cloud (CC) and Document Cloud (DC).

Creative revenues were $803 million, up 39% year over year. Also, Creative ARR increased $258 million to $3.26 billion. DC revenues were $187 million, with DC ARR of $442 million at the end of the fiscal third quarter.

Management is optimistic about Creative Cloud adoption and expects to build a strong pipeline for potential Creative Cloud paid subscribers through marketing programs, trial downloads and free memberships. Management expects growth to be fueled by three initiatives, namely by migrating the Creative Suite installed base, drawing new clients and driving ARPU higher through cloud services like Adobe Stock. Also, Creative Cloud mobile apps are continuously driving customer traffic and strengthening customer adoption.

Within the Digital Marketing segment, Adobe Marketing Cloud revenues were up 10% year over year to $404 million. The improvement came on the back of an increase in the size of accelerated conversions, number of solutions per customer and international expansion. Mobile remains a key component for this business. Mobile data transactions grew to 52% of total Adobe Analytics’ transactions in the quarter.

Margins

Gross margin was 86.2%, up 60 basis points (bps) sequentially and 184 bps year over year. Gross margin is typical of a software company and variations are generally related to the mix of revenues between categories.

Adobe incurred adjusted operating expenses of $856.2 million, reflecting an increase of 4.4% sequentially and 14.1% year over year. As a percentage of sales, research & development, general & administrative and sales & marketing expenses decreased from the year-ago quarter. As a result, adjusted operating margin was 27.7%, up 76 basis points (bps) sequentially and 498 bps year over year.

Net Income

On a GAAP basis, Adobe recorded net income of $270.8 million (54 cents per share) compared with $244.1 million (48 cents per share) in the previous quarter and $174.5 million (34 cents per share) in the year-ago quarter.

On a pro-forma basis, Adobe generated net income of $302.4 million compared with $277.6 million in the previous quarter and $197.3 in the year-ago quarter.

Balance Sheet

Adobe ended the fiscal third quarter with cash and investments balance of $4.45 billion compared with $4.32 billion in the previous quarter. Trade receivables were $731.2 million, up from $666.7 million in the prior quarter. Deferred revenues were $1.75 billion compared with $1.63 billion in the fiscal second quarter.

In the reported quarter, cash generated from operations was $517.9 million and capital expenditure was $55.2 million. Additionally, the company repurchased approximately 3.5 million shares for $344.0 million. Adobe still has $800 million remaining under the current authority granted in Jan 2015.

Guidance

For the fiscal fourth quarter, management expects revenues in the range of $1.55–$1.6 billion. Analysts polled by Zacks expect revenues of $1.58 billion, in line with the guided range at the mid-point.

Based on a share count of 503–505 million, GAAP earnings per share are expected in the range of 60–66 cents, and non-GAAP earnings are projected at 83–89 cents. The Zacks Consensus Estimate is pegged at 63 cents, well below the guided range. Also, non-operating expense is expected within $8–$10 million and the tax rate is likely to be 24% on a GAAP basis and 21% on a non-GAAP basis.

For fiscal 2016, management expects revenues in the range of $5.8–$5.85 billion, GAAP earnings within $2.12 and $2.18 and non-GAAP earnings within $2.94 and $3 per share.

Our Recommendation

Adobe reported strong fiscal third-quarter results wherein both earnings and revenues beat the respective Zacks Consensus Estimate.

We remain positive on Adobe’s market position, compelling product lines, continued innovation and strong balance sheet.

We believe that the company is being driven by continued innovation in its Creative Cloud, Document Cloud and Marketing Cloud businesses.

After the successful transition from traditional license to subscription-based services, Adobe wants to establish its presence in cloud-related software areas like documents and marketing. In this regard, the company has been introducing significant features and a number of updates to its Document Cloud.

In addition, we believe that the constant adoption of Adobe marketing could serves as a catalyst. Moreover, the solid adoption of Document Cloud, a new subscription package that enables users to sign documents on the cloud, should boost revenues.

ADOBE SYSTEMS Price, Consensus and EPS Surprise

ADOBE SYSTEMS Price, Consensus and EPS Surprise | ADOBE SYSTEMS Quote

Adobe carries a Zacks Rank #3 (Hold).

Some better-ranked stocks in the technology sector are Avid Technology, Inc. (AVID - Snapshot Report) and Infoblox Inc. (BLOX - Snapshot Report) sporting a Zacks Rank #1 (Strong Buy), and Aspen Technology, Inc. (AZPN - Snapshot Report) carrying a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.