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Adobe on the Right Track

Richard Saintvilus

NEW YORK ( TheStreet) -- Corporate makeovers are never easy on Wall Street, regardless of whether the business transition has merit.

Not only do conversions create plenty of uncertainty, but they also tend to disrupt the current operation. When the business is disturbed it has an impact on revenue and profits.

While Adobe has certainly earned the Street's patience as management converts its business from the traditional software sold in a box to an online/cloud subscription-based model, I've been impressed by the level of execution. Management has operated flawlessly, which compelled me to ask how long the company can maintain its momentum. Things are not supposed to be this smooth.

Even more impressive is that over the past two years as Adobe was working on this challenge, the stock has jumped from $23.17 in August 2011 to Friday's close of $47. Essentially, investors have embraced Adobe's new model. After posting solid fiscal second-quarter results, I believe it's time to shed the word "transition" in this business. Adobe has arrived.

However, this success has not gone unnoticed. With shares up 23% year-to-date and more than 35% over the past 12 months, I can't say I see any value left. It does seem as if the Street is pricing this stock for perfection. While I don't disagree that Adobe has been very deserving, there's also such as thing as too much optimism. I suspect that this over exuberance applies in this case.

Given this recent quarter has not been too kind to software companies including Oracle and Red Hat , Adobe investors were a bit nervous heading into the quarter. But the company had shown plenty of confidence. The numbers showed why. Before I dive into them, I've reminded you above that business model transitions cause disruptions. So let's keep things in perspective.

The company posted a 10% year-over-year decline in revenue with sales for Adobe's Digital Media business falling 18%. Again, this is because the company is essentially moving away from this business. Besides, the numbers matched Street expectations. Now, with declining revenue figures, you should expect plummeting profitability -- not a big shocker there, either.

The company posted a 2% drop in GAAP gross margin, while GAAP operating income plummeted by more than 60%. It wasn't any better on non-GAAP basis -- operating income fell close to 40% and operating margin decline by roughly 12% year over year.

But here's the thing: The 12% drop in operating margin still arrive higher than Street expectations.

This tells me there's now very little Adobe's management needs to explain during the conference calls regarding the business changeover. Analysts have already plugged the new metrics into their models. It also seems that the numbers they are using in their models have created a spread between management's guidance has turned a bit too bullish.

The fact that Adobe was still able to beat the Street's non-GAAP operating margin target despite a year-over-year 12% drop is the perfect example. In the numbers that do matter, however, Adobe is blowing them out of the water. Not only was there an 11% jump in Digital Marketing revenue, but management posted almost a 20% sales jump Marketing Cloud.

Likewise, Adobe was able to secure an additional 68,000 net new subscribers for its Creative Cloud service, which followed 153,000 that were added in the previous quarter. This means that the company now has a total of 700,000 paid subscribers - an impressive accomplishment considering the service has been available for only just one year.

Management still maintains its goal of achieving 1.25 million paid subscribers by the end of the year. This means the company must secure 550,000 more paid subscribers in the next two quarters, which averages out to 275,000 net subscribers per quarter. Considering Adobe only added 68,000 this quarter and 153,000 net paid subscriptions in the first quarter, the goal of 550,000 in the next two quarter seems a bit too ambitious.

However, I know these guys are smart and companies don't go out of their way to put undue pressure on themselves boasting about high marks they don't feel they can achieve. In that regard, let's not rule out the possibility that customers already on the company's free trial subscription have made commitments to convert to self-pay.

I'm only speculating here, but I understand enough about subscription business model projections to make an educated guess. Even so, I still maintain that this company is heading on the right track.

In that regard, management deserves plenty of credit for what they've been able to accomplish in such a short period of time. Clearly, I like this company. But regarding the stock, I don't see much more upside from here beyond $50 per share. That's to say, is not a great buy at this level, but it's an excellent hold.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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