Business Context and Reporting Period
Adobe Systems Incorporated filed an unaudited Form 10-Q for the quarter ended May 31, 2013, covering the three- and six-month periods compared with May 31, 2012 and June 1, 2012, respectively. The company operates across Digital Media, Digital Marketing, and Print and Publishing. Adobe was transitioning from perpetual software licenses toward Creative Cloud, enterprise term licenses, and other subscription or hosted offerings.
Key Financial Metrics
| Metric | Three Months Ended May 31, 2013 | Year-over-Year Change | Six Months Ended May 31, 2013 | Year-over-Year Change |
|---|---|---|---|---|
| Total revenue | $1.011 billion | Down 10% | $2.018 billion | Down 7% |
| Gross profit | $875.3 million | Down 12% | $1.726 billion | Down 11% |
| Gross margin | 86.6% | Down from 88.4% | 85.5% | Down from 89.0% |
| Operating income | $111.3 million | Down 64% | $209.5 million | Down 65% |
| Operating margin | 11.0% | Down from 27.1% | 10.4% | Down from 27.4% |
| Net income | $76.5 million | Down 66% | $141.7 million | Down 65% |
| Diluted EPS | $0.15 | Down from $0.45 | $0.28 | Down from $0.81 |
- Revenue mix shifted materially: product revenue declined 26% to $644.9 million in the quarter, while subscription revenue increased 60% to $254.5 million. Subscription revenue represented 25% of quarterly revenue versus 14% in the prior-year quarter.
- Digital Media revenue declined 18% to $670.0 million in the quarter, principally because customers moved from perpetual licenses to Creative Cloud and enterprise term licenses. Digital Marketing revenue increased 11% to $285.4 million, supported by Adobe Marketing Cloud growth. Print and Publishing revenue was broadly stable at $55.2 million.
- Total Digital Media annualized recurring revenue was approximately $440 million at May 31, 2013, up $237 million, or 117%, from November 30, 2012. Total deferred revenue was $691.3 million, up 12% from year-end.
- Six-month cash flow from operations was $621.2 million, down 19% from $762.6 million in the prior-year period. Investing cash use was $780.6 million, primarily reflecting purchases of short-term investments, capital expenditures, technology licenses, and the Behance acquisition.
- Cash and cash equivalents were $1.246 billion and short-term investments were $2.619 billion at May 31, 2013. Working capital was $3.293 billion.
- Debt included $1.5 billion of senior notes and approximately $30.0 million of capital lease obligations. Adobe had no borrowings under its $1.0 billion revolving credit facility, which was extended to March 2, 2018. The company reported compliance with applicable covenants.
Material Changes Versus the Prior Comparable Period
- The business model transition reduced near-term reported revenue and profitability because perpetual-license revenue was recognized upfront, while subscription revenue is recognized ratably over the contract term.
- Operating expenses increased 11% in the quarter and 14% for the six-month period, driven principally by higher compensation, headcount, incentive compensation, stock-based compensation, and a property write-down.
- Restructuring and other charges were $25.0 million in the quarter, compared with a $2.2 million benefit in the prior-year quarter. The current-period amount primarily reflected a $23.8 million write-down of Waltham, Massachusetts property assets classified as held for sale.
- Non-operating expense increased to $20.2 million in the quarter from $10.6 million, primarily because prior-year investment gains were replaced by investment losses, including a $5.0 million impairment of a privately held investment.
- Adobe completed its acquisition of Behance for approximately $111.1 million in December 2012. Goodwill increased to $4.225 billion from $4.133 billion at November 30, 2012; no goodwill impairment was identified.
- Adobe repurchased approximately 3.9 million shares for $172.1 million during the quarter and had approximately $1.661 billion remaining under its $2.0 billion repurchase authorization.
Guidance, Outlook, Commentary, Risks, and Unusual Items
- Management expected Creative Cloud adoption to continue accelerating, with perpetual-license revenue and total fiscal 2013 revenue declining during the transition. Expenses were not expected to decline proportionately, creating pressure on fiscal 2013 net income and operating margin.
- Management expected the subscription model to increase recurring and more predictable revenue over time by expanding the customer base, improving customer currency, and increasing average revenue per user. Meaningful renewal-rate data was expected later in fiscal 2013.
- Adobe introduced a managed-services, term-based Adobe Experience Manager offering for which revenue is recognized ratably. Continued adoption could increase recurring revenue but affect the timing of reported Digital Marketing revenue.
- In June 2013, Adobe agreed to acquire Neolane for approximately $600 million in cash, subject to customary closing conditions and expected to close in the third quarter of fiscal 2013. The transaction was expected to be integrated into Digital Marketing.
- Key risks include execution of the Creative Cloud transition, subscription adoption and renewal rates, revenue-recognition timing, cloud infrastructure costs, cybersecurity and privacy exposure, competition, foreign currency movements, intellectual-property litigation, acquisition integration, tax examinations, and reliance on distributors and third-party hosting providers.
- Accrued restructuring obligations were approximately $15.5 million at May 31, 2013, with facility-related payments extending through fiscal 2021. Adobe also disclosed ongoing intellectual-property and ordinary-course legal risks but did not identify a material probable and estimable litigation liability.
- Unrecognized tax benefits were $166.6 million, excluding interest and penalties. The filing stated that potential decreases in underlying unrecognized tax benefits within the next 12 months could range from zero to approximately $5 million.
Important Facts for Investors to Verify
- Whether Creative Cloud subscription growth and the approximately $440 million Digital Media ARR offset continued declines in perpetual-license revenue.
- Subscription renewal rates, customer acquisition costs, average revenue per user, and the effect of ratable revenue recognition on future reported results and cash flow.
- The timing, funding, accounting treatment, and strategic contribution of the proposed $600 million Neolane acquisition.
- Progress in selling the Waltham property and whether additional valuation adjustments or restructuring costs arise.
- Debt maturities, interest expense, compliance with credit and lease covenants, and the continued availability of the $1.0 billion revolving facility.
- Exposure to foreign exchange, cybersecurity, privacy, intellectual-property, tax, and hosted-service interruption risks.