Intuit's Cloud Transition Is Becoming Less Taxing

Software maker Intuit (INTU) - Get Report reports third-quarter fiscal 2016 earnings on Tuesday after the close. I expect another strong quarter, and the stock should rally.

In February, when Intuit reported its second quarter, it said a solid tax season set it up for a strong 2016. Intuit beat the consensus estimate by $29 million and posted revenue of $923 million. It earned 25 cents a share, 6 cents ahead of analyst estimates.

Turbo Tax Online units grew 12%, during a period where tax filings fell 1%. About 50% of revenue comes from tax filings, so it's an important growth driver. The small business segment, which includes products like accounting, payroll, merchant services and card processing, accounts for the rest of sales.

While the tax business is off to a strong start, the outlook for the small business segment is somewhat mixed. Online payment-attach rates were just 8%, down from a high of 12% in the first quarter. (The attach rate is the rate at which customers buy additional services from Intuit. For example, only 8% of QuickBooks users bought an online payment service.) Payroll-attach rates were also down to 21% after hitting a record rate last year.  You would think attachment rates would be higher since QuickBooks online grew subscribers by 49%.

For the third quarter, analysts think the company will post $2.25 billion in revenue, up 5.4%, and earn $3.21 a share. With tax season in the quarter, the third quarter is Intuit's seasonally strongest quarter.

Second-quarter revenue grew 16%, and with the third quarter up another 5.4%, the company should end the year with revenue of $4.6 billion.

As Intuit moves customers away from pre-packaged software to the cloud, revenue should continue to grow. Initially, operating margins were hurt by the expensive transition. But, with the bulk of the heavy investment in the cloud behind it, margins should being to return to normal over the next two years, which will help drive earnings per share.

Operating margins bottomed out in fiscal 2015 at 26.3%, but should hit 32% this year and go as high as 38% by fiscal 2018. With the dramatic recovery in operating margins, gross profits should surge into next year. Gross profit bottomed out at negative 6% in fiscal 2015, but should increase nearly 14% next year.

We saw much the same thing with Adobe (ADBE) - Get Report . Adobe's stock stalled out in 2014 as the company transitioned users from pre-packaged software to cloud subscriptions. While there were a few dicey quarters, margins and profits came roaring back. I expect the same reaction from Intuit.

This is the year the transition to the cloud is becoming less taxing.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.