Adobe Systems Incorporated — Fiscal Q1 2018 Form 10-Q
Business context and reporting period
The filing covers the three months ended March 2, 2018, compared with the three months ended March 3, 2017. Adobe operates Digital Media, Digital Experience and Publishing businesses, with growth centered on Creative Cloud, Document Cloud and Adobe Experience Cloud subscriptions. The company reorganized its reportable segments in fiscal 2018 and moved Connect and LiveCycle from Digital Experience to Publishing.
Financial performance and liquidity
| Metric | Q1 FY2018 | Q1 FY2017 | Change |
|---|---|---|---|
| Total revenue | $2,078.9 million | $1,681.6 million | +24% |
| Subscription revenue | $1,793.4 million | $1,383.9 million | +30% |
| Gross profit | $1,820.0 million | $1,444.3 million | +26% |
| Gross margin | 87.5% | 85.9% | +160 bps |
| Operating income | $702.7 million | $469.0 million | +50% |
| Operating margin | 33.8% | 27.9% | +590 bps |
| Net income | $583.1 million | $398.4 million | +46% |
| Diluted EPS | $1.17 | $0.80 | +46% |
| Cash flow from operations | $989.6 million | $730.4 million | +35% |
- Revenue mix continued shifting toward subscriptions: subscription revenue represented 86% of total revenue versus 82% in the prior-year quarter. Product revenue declined 6% to $171.6 million, while services and support revenue was essentially flat at $114.0 million.
- Digital Media revenue was $1.46 billion, up 28%; Digital Experience revenue was $554.1 million, up 16%; and Publishing revenue was $64.3 million, down 3%.
- Digital Media annualized recurring revenue reached $5.72 billion at quarter-end, up from $5.39 billion at December 1, 2017. Creative ARR was $5.07 billion and Document Cloud ARR was $647 million.
- Deferred revenue totaled approximately $2.57 billion, up 3% from December 1, 2017.
- Cash and cash equivalents were $2.67 billion and short-term investments were $3.48 billion at March 2, 2018. Working capital was $3.94 billion.
- Investing cash outflow was $93.7 million, primarily for property and equipment and short-term investments. Financing cash outflow was $541.3 million, including $300.0 million of treasury-stock repurchases and $305.4 million of taxes paid on net share settlements.
- Total debt had a carrying value of $1.87 billion and fair value of $1.93 billion, consisting of $900 million of 4.75% senior notes due 2020 and $1.0 billion of 3.25% senior notes due 2025. The $1.0 billion revolving credit facility was undrawn, and Adobe reported compliance with applicable covenants.
- Stock-based compensation expense was $135.5 million, compared with $100.9 million in the prior-year quarter, and $1.19 billion of unrecognized compensation cost remained at quarter-end.
Material changes versus the prior comparable period
- Growth was driven primarily by Creative Cloud, Document Cloud and Experience Cloud subscription adoption. Creative revenue increased 30% to $1.23 billion, and Document Cloud revenue increased to $231.0 million from $195.9 million.
- Operating expenses increased 15% to $1.12 billion, reflecting higher headcount, incentive compensation and stock-based compensation. Research and development rose 22%, sales and marketing rose 12%, and general and administrative expense rose 13%.
- Cost of revenue increased 9% to $258.9 million, including higher hosting, data-center, royalty and media costs.
- The effective tax rate increased to approximately 17% from 14%, primarily because of the Tax Cuts and Jobs Act. Adobe recorded a provisional $118 million transition-tax expense and a provisional $10 million deferred-tax remeasurement charge. The accounting remained subject to revision as further guidance became available.
- Cash flow from operations increased substantially, partly because of higher net income and a $511.3 million increase in income-tax liabilities related principally to the provisional transition tax.
- Adobe repurchased approximately 1.6 million shares at an average price of $185.13. Following a subsequent $700 million structured repurchase agreement, $900 million remained under the authorized $2.5 billion repurchase program.
Guidance, outlook, commentary and risks
Management did not provide specific full-year quantitative guidance in the supplied filing. Management described strong execution of its long-term strategy, continued investment in subscription and service offerings, and expectations that Creative Cloud would support recurring and predictable revenue growth through customer acquisition, retention and expanded functionality. Adobe stated that existing cash, investments, operating cash flows and available credit were expected to satisfy working-capital and operating requirements for at least the next twelve months.
- The fiscal 2019 adoption of the new revenue-recognition standard is expected to change the timing of revenue recognition for certain on-premise term-based licenses and require capitalization of certain incremental contract-acquisition costs. Adobe planned modified retrospective adoption and was still evaluating the impact.
- The provisional Tax Act accounting may change materially as tax returns, audits and regulatory guidance are finalized. The estimated $533 million long-term transition-tax liability is payable over eight years beginning in fiscal 2019.
- Key operating risks include subscription renewal and attrition rates, competition and pricing pressure, complex enterprise sales cycles, cybersecurity and service outages, dependence on third-party data centers and support providers, foreign-currency movements, privacy and data-transfer regulation, intellectual-property litigation, tax examinations, acquisition integration and potential goodwill or intangible-asset impairment.
- Adobe reported no material investment impairment, no material changes in market-risk exposures, no outstanding borrowings under its revolving credit facility and effective disclosure controls as of March 2, 2018.
Important facts for investors to verify
- Confirm the final accounting effects of the Tax Cuts and Jobs Act, including the transition-tax liability, deferred-tax remeasurement and future cash-tax payments.
- Track Digital Media ARR, subscription growth, renewal rates and deferred revenue as indicators of future recurring revenue.
- Assess whether operating-expense growth, stock-based compensation and infrastructure costs remain below revenue growth.
- Review the timing and accounting impact of fiscal 2019 revenue-recognition adoption.
- Monitor the remaining share-repurchase authorization, dilution from equity awards and the effect of repurchases on share count.
- Evaluate debt maturities, interest-rate exposure, liquidity and compliance with credit-facility covenants.
- Review cybersecurity, privacy, service-continuity, intellectual-property, tax-audit and other contingencies disclosed in the filing.