Adobe Systems Incorporated — Fiscal 2015 Third-Quarter Form 10-Q
Business context and reporting period
Adobe reported results for the three and nine months ended August 28, 2015, compared with August 29, 2014. The business comprises Digital Media, Digital Marketing, and Print and Publishing. Management continued emphasizing the transition from perpetual licenses to recurring subscription and cloud-based offerings, particularly Creative Cloud, Document Cloud, and Adobe Marketing Cloud.
Financial performance and liquidity
| Metric | Q3 FY2015 | Q3 FY2014 | 9M FY2015 | 9M FY2014 |
|---|---|---|---|---|
| Total revenue | $1.218 billion | $1.005 billion | $3.489 billion | $3.074 billion |
| Subscription revenue | $829.1 million | $547.4 million | $2.316 billion | $1.448 billion |
| Gross profit | $1.027 billion | $847.7 million | $2.946 billion | $2.613 billion |
| Operating income | $246.0 million | $74.2 million | $612.7 million | $288.2 million |
| Net income | $174.5 million | $44.7 million | $406.8 million | $180.3 million |
| Diluted EPS | $0.34 | $0.09 | $0.80 | $0.35 |
| Operating cash flow | Not separately provided | Not separately provided | $1.015 billion | $887.7 million |
Q3 gross margin was approximately 84.3%, operating margin approximately 20.2%, and net margin approximately 14.3%. Nine-month gross margin was approximately 84.4%, operating margin approximately 17.6%, and net margin approximately 11.7%.
- Q3 revenue increased 21%; nine-month revenue increased 14% year over year.
- Subscription revenue represented 68% of Q3 revenue versus 54% in the prior-year quarter; nine-month subscription mix was 66% versus 47%.
- Q3 Digital Media revenue rose 24% to $769.6 million and Digital Marketing revenue rose 20% to $402.5 million. Print and Publishing declined 4% to $45.6 million.
- Digital Marketing revenue was $368.4 million, up 27% year over year, led by continued adoption of Adobe Experience Manager, Adobe Campaign, and Adobe Analytics.
- Q3 cost of revenue increased 21% to $191.0 million, primarily from higher data-center, royalty, compensation, and Fotolia-related amortization costs.
- Cash, cash equivalents, and short-term investments totaled $3.669 billion at August 28, 2015. Working capital was $2.465 billion.
- Cash decreased $288.1 million during the first nine months, principally reflecting $1.202 billion of investing outflows, including the Fotolia acquisition and investment purchases.
- Debt had a carrying value of $1.906 billion, consisting of $900 million of 2020 Notes and $1.0 billion of 2025 Notes. The $1.0 billion revolving credit facility was undrawn, and all reported covenants were satisfied.
Material changes versus the prior comparable period
- Net income increased 290% in Q3 and 126% for the first nine months, primarily because of higher revenue and operating leverage.
- Operating income increased 232% in Q3 and 113% year to date, while operating expenses were broadly stable.
- Creative Cloud paid subscriptions reached 5.334 million, up 54% from fiscal year-end 2014. Creative ARR reached $2.29 billion, versus $1.61 billion at fiscal year-end 2014.
- Total Digital Media ARR reached approximately $2.65 billion, up 41% from $1.88 billion at fiscal year-end 2014. Document Cloud ARR increased to $357.0 million from $265.0 million.
- Deferred revenue increased 13% from November 28, 2014 to approximately $1.31 billion.
- Adobe completed the $807.5 million acquisition of Fotolia in January 2015 and launched Adobe Stock in June 2015. The transaction increased goodwill and intangible assets and contributed to higher amortization and royalty costs.
- Adobe issued $1.0 billion of 3.25% senior notes due 2025 and used $600 million of proceeds to repay notes due in February 2015.
- The company repurchased approximately 6.7 million shares for an average $75.93 per share during the first nine months and had $1.735 billion remaining under its current authorization at quarter-end.
- Accumulated other comprehensive loss increased to $140.8 million, substantially reflecting foreign-currency translation and derivative-related changes.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide a clear numerical full-year revenue or earnings guidance table. Management expects subscription revenue to continue increasing as investments in SaaS and subscription models continue. Management also expects foreign-currency fluctuations to negatively affect reported revenue growth during the remainder of fiscal 2015.
- Management described strong demand for Adobe Marketing Cloud and expects that demand to benefit revenue growth in future quarters.
- Management considers restructuring plans substantially complete; $4.6 million remained accrued at quarter-end, with related facility obligations extending through fiscal 2021.
- The HTEAL employee-antitrust litigation settlement received final court approval on September 2, 2015, and Adobe expected no additional losses from the matter.
- Adobe held $254.6 million of gross unrecognized tax benefits, excluding interest and penalties, and reported $27.0 million of accrued interest and penalties. Tax audits and settlements remain uncertain.
- Key risks include execution of the transition to subscription and cloud models, customer renewal rates, pricing and promotional pressure, cybersecurity and service availability, privacy regulation, foreign exchange, competition, acquisition integration, intellectual-property disputes, tax examinations, and debt-service obligations.
- The new revenue-recognition standard was expected to become effective for Adobe in the first quarter of fiscal 2019; the company had not selected a transition method or determined the financial statement impact.
- Adobe stated that existing cash, investments, operating cash flow, and available credit were expected to satisfy working-capital and operating requirements for at least the next twelve months.
Important facts for investors to verify
- Whether Creative Cloud subscription growth, ARR expansion, and renewal rates continue at the reported pace.
- The sustainability of the shift toward subscription revenue and its effects on deferred revenue, cash flow, and margins.
- Foreign-currency effects and the effectiveness of Adobe’s hedging program.
- Integration results, incremental costs, and impairment exposure associated with Fotolia and Adobe Stock.
- The outcome and timing of tax examinations, including the potential realization of unrecognized tax benefits.
- Debt maturities, interest-rate exposure under the 2020 Notes swaps, and compliance with credit and lease covenants.
- Cybersecurity, privacy, intellectual-property, and hosted-service incidents that could affect customer retention or create liabilities.
- The effect of the new revenue-recognition standard when adopted in fiscal 2019.