Adobe Systems Incorporated — Form 10-Q Summary
Business context and reporting period
Quarterly report for the three and six months ended May 30, 2014, compared with May 31, 2013. Adobe provides creative, digital marketing, document, publishing and related software and services through perpetual licenses, subscriptions, hosted services and enterprise term license agreements. The company is transitioning from perpetual Creative Suite licensing to recurring Creative Cloud subscriptions.
Financial performance
| Metric | Q2 FY2014 | Q2 FY2013 | Change |
|---|---|---|---|
| Total revenue | $1.068 billion | $1.011 billion | +6% |
| Subscription revenue | $476.7 million | $254.5 million | +87% |
| Product revenue | $479.2 million | $644.9 million | -26% |
| Gross profit | $913.3 million | $875.3 million | +4% |
| Gross margin | 85.5% | 86.6% | Down 1.1 points |
| Operating income | $135.3 million | $111.3 million | +22% |
| Operating margin | 12.7% | 11.0% | Up 1.7 points |
| Net income | $88.5 million | $76.5 million | +16% |
| Diluted EPS | $0.17 | $0.15 | Increase |
For the six months, revenue was $2.068 billion, up 2%; gross profit was $1.765 billion; operating income was $214.0 million; net income was $135.6 million versus $141.7 million in the prior-year period; and diluted EPS was $0.27 versus $0.28. Six-month gross margin was approximately 85.3%, operating margin 10.3% and net margin 6.6%.
- Digital Media revenue was $691.6 million in Q2, up 3% year over year; six-month revenue declined 2% to $1.333 billion.
- Digital Marketing revenue was $330.3 million in Q2, up 16%; six-month revenue increased 17% to $644.7 million.
- Print and Publishing revenue declined 16% in Q2 and 15% for the six months, reflecting lower legacy revenue and the absence of a prior-year nonrecurring font transaction.
- Creative Cloud ended the quarter with 2.308 million paid subscriptions, up 60% from 1.439 million at fiscal 2013 year-end. Creative ARR was $1.20 billion.
- Total Digital Media ARR was approximately $1.38 billion, up 46% from $944 million at fiscal 2013 year-end. Document Services ARR was $183 million.
Cash flow, liquidity and capital structure
| Metric | Six months ended May 30, 2014 | Six months ended May 31, 2013 |
|---|---|---|
| Cash flow from operations | $619.2 million | $621.2 million |
| Cash flow used in investing | $242.4 million | $780.6 million |
| Cash flow used in financing | $394.1 million | $11.2 million |
| Net change in cash | $(17.5) million | $(178.6) million |
- At May 30, 2014, cash and cash equivalents were $817.0 million and short-term investments were $2.513 billion, for total cash and short-term investments of approximately $3.330 billion.
- Working capital was $1.896 billion, compared with $2.520 billion at November 29, 2013, primarily reflecting the reclassification of the 2015 Notes as current debt.
- Senior notes totaled $1.5 billion: $600 million of 3.25% notes due February 2015 and $900 million of 4.75% notes due February 2020. Adobe intends to refinance the 2015 Notes on or before maturity.
- The $1.0 billion revolving credit facility was undrawn and available; Adobe reported compliance with applicable debt and lease covenants.
- Adobe paid $350 million under structured stock repurchase agreements during the first six months and repurchased approximately 7.1 million shares at an average price of $60.55. Approximately $500.8 million remained under the repurchase authorization at May 30, 2014.
Material changes, outlook and unusual items
- The business model continued shifting materially toward subscriptions: subscription revenue represented 45% of Q2 revenue versus 25% in the prior-year quarter. Product revenue fell as perpetual Creative Suite licensing declined.
- Adobe stated that perpetual revenue from creative professional products was expected to become immaterial in the second half of fiscal 2014. Q2 included a final surge in channel-driven CS6 volume licensing before broader availability was removed.
- Higher subscription and hosted-service usage increased data-center, hosting, depreciation and personnel costs. Operating expenses rose 2% in Q2, while cost of revenue increased 14%.
- Adobe Marketing Cloud revenue increased 23% in Q2 to $282.9 million, supported by Adobe Experience Manager and the Neolane acquisition. Managed-services adoption is expected to make more Digital Marketing revenue recurring, but may affect reported growth in the near term because revenue is recognized over time.
- The effective tax rate increased to 27% from 16% in Q2, primarily due to expiration of the federal research and development tax credit and weaker forecasted international profits.
- A $10 million loss contingency was accrued for the High-Tech Employee Antitrust Litigation settlement reached during the quarter, subject to court approval. Restructuring plans were substantially complete, with $9.7 million accrued at quarter-end.
- Goodwill impairment testing identified no impairment. Adobe adopted no material accounting-policy changes, but was evaluating the impact of the new revenue-recognition standard effective in fiscal 2018.
- Management stated that existing cash, investments, operating cash flow and available credit were sufficient for the next twelve months. The filing does not provide clear numerical full-year revenue or earnings guidance.
Key risks and contingencies
- Execution risk in the transition to subscription and cloud models, including customer adoption, pricing, renewal rates, deferred revenue timing and short-term pressure from declining perpetual licenses.
- Cybersecurity, privacy, data protection, service availability and third-party hosting risks affecting Creative Cloud, Marketing Cloud and customer data.
- Competition, technological change, mobile and tablet platform shifts, piracy and intellectual-property litigation.
- Foreign-exchange exposure, international regulatory and tax changes, and the impact of weaker APAC revenue.
- Refinancing risk associated with the $600 million of notes due in February 2015 and potential adverse outcomes from litigation, tax examinations or indemnification obligations.
Investor verification checklist
- Verify the sustainability of Creative Cloud subscription growth, ARR expansion and renewal rates as perpetual-license revenue declines.
- Reconcile ARR, deferred revenue and reported revenue, recognizing that ARR is a management performance metric and is not interchangeable with revenue.
- Assess the effect of hosting and infrastructure costs on subscription gross margins and operating leverage.
- Confirm refinancing plans and terms for the 2015 Notes before maturity.
- Monitor the High-Tech Employee Antitrust Litigation settlement, tax examinations and other legal or intellectual-property contingencies.
- Review foreign-exchange effects, particularly the impact of the Japanese yen and APAC performance.