Adobe Systems Incorporated — Fiscal 2018 Third-Quarter Form 10-Q
Business context and reporting period
Filed for the quarter ended August 31, 2018, with comparative periods ended September 1, 2017. Adobe provides creative, document, digital marketing, advertising, analytics, commerce, publishing and related cloud-based software and services through its Digital Media, Digital Experience and Publishing segments.
Management emphasized continued growth in Creative Cloud, Document Cloud and Adobe Experience Cloud, with Magento Commerce acquired during the quarter and integrated into Digital Experience.
Financial performance and liquidity
| Metric | Three months ended August 31, 2018 | Year-over-year change | Nine months ended August 31, 2018 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $2.291 billion | 24% | $6.565 billion | 24% |
| Subscription revenue | $2.022 billion | 29% | $5.738 billion | 29% |
| Gross profit | $1.996 billion | 26% | $5.730 billion | 26% |
| Gross margin | 87.1% | Up from 85.7% | 87.3% | Up from 86.0% |
| Operating income | $718.6 million | 32% | $2.120 billion | 40% |
| Operating margin | 31.4% | Up from 29.6% | 32.3% | Up from 28.7% |
| Net income | $666.3 million | 59% | $1.913 billion | 60% |
| Diluted EPS | $1.34 | Up from $0.84 | $3.84 | Up from $2.38 |
- Digital Media revenue was $1.609 billion in the quarter, up 27%; Digital Experience revenue was $614.0 million, up 21%; Publishing revenue was $68.2 million, up 8%.
- Digital Media annualized recurring revenue reached $6.40 billion, up from $5.39 billion at fiscal year-end 2017. Creative ARR was $5.66 billion and Document Cloud ARR was $744 million.
- Nine-month operating cash flow was $2.921 billion, up 40% from $2.080 billion. Investing cash flow used $1.546 billion, primarily for the Magento acquisition, investments and capital expenditures. Financing cash flow used $1.930 billion, primarily for share repurchases and employee tax withholding.
- Cash and cash equivalents were $1.747 billion and short-term investments were $3.197 billion at August 31, 2018, compared with $2.306 billion and $3.514 billion, respectively, at December 1, 2017. Working capital was $2.509 billion.
- Total debt was approximately $1.875 billion carrying value, consisting of $900 million of 2020 senior notes and $1.0 billion of 2025 senior notes. The $1.0 billion revolving credit facility was undrawn, and Adobe reported compliance with all debt covenants.
Material changes versus the prior comparable period
- Revenue growth remained concentrated in recurring subscriptions: subscription revenue increased to 88% of total revenue from 85% in the third quarter of fiscal 2017, while product revenue declined 6%.
- Operating expenses increased 24% in the quarter and 19% year to date, driven principally by headcount growth, compensation, stock-based compensation and Magento-related personnel and transaction costs.
- The effective tax rate declined to 5% in the quarter and 9% year to date, compared with 23% and 20%, respectively, primarily reflecting the Tax Cuts and Jobs Act and changes to Adobe’s tax structure. Tax Act accounting remained provisional.
- Magento was acquired on June 18, 2018 for an estimated purchase price of $1.645 billion, including $1.316 billion of goodwill and $395.8 million of identifiable intangible assets. Goodwill increased to $7.137 billion from $5.822 billion at December 1, 2017.
- Adobe repurchased approximately 7.1 million shares for $1.75 billion during the nine-month period. In May 2018, the Board authorized an additional $8 billion repurchase program through fiscal 2021.
Guidance, outlook, commentary and risks
- Management stated that Creative Cloud, Document Cloud, Adobe Experience Cloud and Magento are expected to support continued long-term growth, but the filing does not provide a clear numerical quarterly or annual revenue and earnings guidance target.
- Adobe expects to adopt the new revenue recognition standard in the first quarter of fiscal 2019 using the modified retrospective method. Annual revenue is not expected to change materially, but adoption may materially affect deferred revenue, retained earnings, contract-cost assets, disclosures and the timing or classification of certain revenue.
- Adobe announced a subsequent agreement to acquire Marketo for approximately $4.75 billion, subject to regulatory approval and customary closing conditions, with expected closing in the fourth quarter of fiscal 2018. The company expected to use cash, investments, newly issued debt or its revolving facility to finance the transaction.
- Key risks include subscription renewal and customer attrition, intense competition, extended enterprise sales cycles, cybersecurity and service outages, privacy and data-transfer regulation, foreign currency exposure, intellectual-property litigation, acquisition integration, tax uncertainty, goodwill impairment and the concentration of critical operations and data centers in earthquake-prone regions.
- Adobe reported no material changes in market-risk exposures, effective disclosure controls, and no material changes to contractual obligations or off-balance-sheet arrangements during the nine-month period.
Important facts for investors to verify
- Whether recurring-revenue and ARR growth continues after incorporating Magento and as Adobe transitions to the fiscal 2019 revenue standard.
- The final accounting and cash-tax effects of the Tax Act, including the provisional $427 million transition-tax liability and unrecognized tax benefits.
- Funding, leverage and integration costs associated with the approximately $4.75 billion Marketo acquisition.
- Cash conversion after substantial share repurchases, acquisitions and potential additional debt financing.
- Customer renewal rates, subscription trends, enterprise sales-cycle timing and the sustainability of Digital Media and Digital Experience margins.
- Potential effects of cybersecurity incidents, privacy regulation, foreign exchange movements, intellectual-property matters and goodwill or intangible-asset impairment.