Adobe Inc. 2019 Third-Quarter Form 10-Q Summary
Business context and reporting period
Adobe is a global software company offering Creative Cloud, Document Cloud, Experience Cloud, publishing, and related services through subscription, hosted, term-license, perpetual-license, and usage-based models. The filing covers the three and nine months ended August 30, 2019, compared with August 31, 2018. Fiscal 2019 results reflect adoption of ASC 606 using the modified retrospective method; prior periods were not restated, limiting comparability.
Key financial metrics
| Metric | Q3 2019 | Q3 2018 | Change |
|---|---|---|---|
| Revenue | $2.834 billion | $2.291 billion | +24% |
| Gross profit | $2.418 billion | $1.996 billion | +21% |
| Gross margin | 85.3% | 87.1% | Down 180 bps |
| Operating income | $853.8 million | $718.6 million | +19% |
| Operating margin | 30.1% | 31.4% | Down 130 bps |
| Net income | $792.8 million | $666.3 million | +19% |
| Diluted EPS | $1.61 | $1.34 | +20% |
| Metric | Nine months 2019 | Nine months 2018 | Change |
|---|---|---|---|
| Revenue | $8.179 billion | $6.565 billion | +25% |
| Gross profit | $6.959 billion | $5.730 billion | +21% |
| Operating income | $2.298 billion | $2.120 billion | +8% |
| Net income | $2.100 billion | $1.913 billion | +10% |
| Diluted EPS | $4.26 | $3.84 | +11% |
| Cash flow from operations | $3.045 billion | $2.921 billion | +4% |
Subscription revenue was $2.547 billion in the quarter, or 90% of total revenue, up 26% year over year. Digital Media revenue increased 22% to $1.962 billion, including Creative Cloud revenue of $1.655 billion and Document Cloud revenue of $307.5 million. Digital Experience revenue increased 34% to $820.9 million, with subscription revenue up 37% to $678.7 million. Publishing revenue declined 25% in the quarter to $51.0 million.
Q3 gross margin was 85.3%. Higher subscription and services costs, including amortization of acquired intangibles, reduced margins. Cost of revenue increased 41% to $416.0 million. Operating expenses increased 23% to $1.564 billion, driven primarily by headcount, compensation, stock-based compensation, marketing, and acquisition-related amortization.
Liquidity, cash flow, debt, and capital allocation
- Cash and cash equivalents were $2.209 billion and short-term investments were $1.442 billion at August 30, 2019, for combined liquidity of approximately $3.651 billion.
- Operating cash flow for the first nine months was $3.045 billion. Investing cash outflow was $287.2 million, and financing cash outflow was $2.180 billion.
- Adobe repurchased approximately 7.1 million shares for $2.0 billion during the first nine months and repurchased 2.6 million shares for $750.0 million during the quarter. Approximately $6.10 billion remained under the repurchase authorization at quarter-end; a subsequent $750 million structured repurchase agreement reduced remaining authority to approximately $5.1 billion.
- Total debt was approximately $4.14 billion, consisting primarily of a $2.25 billion term loan due April 2020 and senior notes with approximately $1.89 billion carrying value, including $900 million of notes due February 2020 and $1.0 billion due February 2025.
- The $1.0 billion revolving credit facility was undrawn and fully available. Adobe stated that it was in compliance with debt covenants and intended to refinance the term loan and 2020 Notes on or before their due dates.
- Working capital was a deficit of $2.053 billion versus a surplus of $555.9 million at November 30, 2018, primarily because the term loan and 2020 Notes were reclassified as current liabilities.
Material changes versus the prior comparable period
- Revenue growth remained concentrated in recurring subscription offerings, which increased from 88% to 90% of quarterly revenue.
- Digital Experience benefited substantially from the Marketo acquisition, completed in October 2018. Marketo-related amortization and integration-related headcount contributed to higher costs.
- Adobe acquired Allegorithmic in January 2019 for approximately $159.7 million total purchase price, including the fair value of its previously held interest. The transaction generated an investment gain of approximately $41.5 million.
- Amortization of purchased intangibles increased materially, contributing to a 41% increase in quarterly cost of revenue and an 80% increase in quarterly operating-expense amortization.
- Interest expense increased to $39.5 million in the quarter and $120.7 million for the nine-month period, primarily because of debt incurred to fund the Marketo acquisition.
- ASC 606 adoption increased opening retained earnings by $442.3 million and capitalized approximately $413.2 million of contract acquisition costs. Without ASC 606, reported Q3 revenue and net income would have been approximately $2.799 billion and $752.1 million, respectively, according to the filing.
Guidance, outlook, commentary, and risks
Management did not provide a new quantitative earnings or revenue forecast in the supplied filing text. Management described strong execution in Digital Media and Digital Experience and expects Creative Cloud, Document Cloud, Marketo, Commerce Cloud, and other Experience Cloud offerings to support future growth. Digital Media annualized recurring revenue was approximately $7.86 billion at quarter-end, up from $6.71 billion at fiscal year-end 2018; Creative ARR was $6.87 billion and Document Cloud ARR was $993 million.
Management stated that approximately 74% of remaining performance obligations, excluding certain enterprise committed-fund arrangements, was expected to be recognized within the next 12 months. Remaining performance obligations were approximately $8.77 billion at August 30, 2019.
- Adobe expects to refinance the term loan and 2020 Notes before maturity; execution and refinancing costs are important liquidity considerations.
- Major risks include intense competition, pricing and renewal pressure, extended enterprise sales cycles, execution and integration risks from acquisitions, cybersecurity and service outages, privacy and data-transfer regulation, foreign-currency volatility, tax-law changes, intellectual-property litigation, and potential impairment of goodwill or acquired intangible assets.
- The company entered into a $1.0 billion Treasury lock arrangement to hedge benchmark interest rates on anticipated refinancing debt.
- Adobe amended vendor agreements creating an aggregate incremental minimum purchase commitment of approximately $1.74 billion through May 2024.
- An accrued Tax Cuts and Jobs Act transition-tax liability of approximately $427.1 million is payable in installments through fiscal 2026.
- Adobe stated that existing cash, investments, expected operating cash flow, and available credit were sufficient to meet operating and working-capital requirements for the next 12 months.
Important facts for investors to verify
- Reconcile ASC 606-adjusted results with prior-period results and assess the effect of contract-cost capitalization and revenue timing on reported growth.
- Monitor the refinancing of the $2.25 billion term loan and approximately $900 million of 2020 Notes, including interest rates and leverage-covenant compliance.
- Evaluate whether Marketo integration produces sustained Digital Experience growth without continued disproportionate amortization and operating-cost increases.
- Track Digital Media ARR, subscription additions, renewal rates, and the conversion of remaining performance obligations into revenue and cash flow.
- Assess the sustainability of margins in light of higher hosting, media, royalty, compensation, and acquired-intangible amortization costs.
- Review the scale of stock repurchases relative to debt refinancing needs, acquisition spending, and operating cash generation.