Adobe Systems Incorporated — Fiscal Q3 2014 Form 10-Q Summary
Business context and reporting period
Adobe Systems Incorporated is a global software company serving creative professionals, marketers, enterprises, developers and consumers through Digital Media, Digital Marketing, and Print and Publishing offerings. The company is transitioning from perpetual software licenses toward subscription, hosted and enterprise term-license models, including Creative Cloud and Adobe Marketing Cloud.
This unaudited Form 10-Q covers the three and nine months ended August 29, 2014, compared with the comparable periods ended August 30, 2013. The fiscal quarter was the third quarter of fiscal 2014.
Financial performance and liquidity
| Metric | Q3 FY2014 | Q3 FY2013 | Change | 9M FY2014 | 9M FY2013 |
|---|---|---|---|---|---|
| Total revenue | $1,005.4 million | $995.1 million | +1% | $3,073.7 million | $3,013.5 million |
| Subscription revenue | $547.4 million | $299.3 million | +83% | $1,447.6 million | $778.1 million |
| Product revenue | $349.1 million | $582.2 million | -40% | $1,299.9 million | $1,902.9 million |
| Gross profit | $847.7 million | $848.0 million | Flat | $2,612.6 million | $2,574.5 million |
| Operating income | $74.2 million | $110.4 million | -33% | $288.2 million | $319.9 million |
| Net income | $44.7 million | $83.0 million | -46% | $180.3 million | $224.7 million |
| Diluted EPS | $0.09 | $0.16 | -44% | $0.35 | $0.44 |
Q3 gross margin was approximately 84.3%, operating margin approximately 7.4%, and net margin approximately 4.4%. For the first nine months, gross margin was approximately 85.0%, operating margin approximately 9.4%, and net margin approximately 5.9%.
- Digital Media revenue was $621.4 million in Q3, down 2% year over year; Digital Marketing revenue was $336.6 million, up 8%; Print and Publishing revenue was $47.4 million, up 1%.
- Digital Media gross margin was approximately 94%, Digital Marketing approximately 65%, and Print and Publishing approximately 96% in Q3.
- Net cash provided by operating activities was $887.7 million for the first nine months, versus $836.7 million in the prior-year period.
- Capital expenditures were $111.6 million. Investing cash outflow was $412.7 million, and financing cash outflow was $403.9 million.
- Cash and cash equivalents were $903.3 million and short-term investments were $2.6169 billion at August 29, 2014, for total cash and short-term investments of approximately $3.5202 billion.
- Working capital was $2.0342 billion, compared with $2.5203 billion at November 29, 2013, primarily reflecting the reclassification of the 2015 Notes as current debt.
- Total debt and capital lease obligations were approximately $1.508 billion, including $599.9 million of current debt and $901.8 million of long-term debt and capital lease obligations.
- Adobe had no borrowings under its $1.0 billion revolving credit facility, which matures March 2, 2018, and was in compliance with applicable covenants.
Material changes versus the prior comparable period
- The revenue mix shifted materially toward subscriptions: subscription revenue represented 54% of Q3 revenue versus 30% in the prior-year quarter and 47% versus 26% for the first nine months.
- Product revenue declined as Adobe discontinued general availability of perpetual CS6 licensing through certain channels, while subscription revenue increased substantially.
- Q3 operating expenses increased 5% to $773.5 million, primarily because of higher compensation, stock-based compensation and related benefits. Cost of revenue increased 7% to $157.7 million due mainly to hosting, server, royalty and personnel costs associated with subscription and SaaS offerings.
- The effective tax rate increased to approximately 29% in Q3 from 11%, and to approximately 28% for the first nine months from 16%. Drivers included expiration of the federal research and development tax credit, stronger U.S. profits and prior-year tax benefits from completed examinations.
- Non-operating expense improved to $11.2 million in Q3 from $17.1 million, and to $39.1 million for the first nine months from $52.0 million, partly because of lower interest expense and improved investment results.
- Adobe repurchased approximately 9.0 million shares for $475.0 million during the first nine months, compared with approximately 13.7 million shares for $700.0 million in the prior-year period. Approximately $367.3 million remained under the repurchase authority at quarter-end; a subsequent $125.0 million structured repurchase reduced remaining authority to $200.0 million.
- Adobe exercised its option to purchase the East and West Towers for $143.2 million. A $126.8 million lease receivable was credited against the purchase price, and the buildings were capitalized as property and equipment.
Guidance, outlook, commentary, risks and unusual items
- Management expects perpetual revenue from creative professional products to be immaterial in Q4 FY2014 as the transition to Creative Cloud continues.
- Adobe exited Q3 with 2.810 million paid Creative Cloud subscriptions, up 95% from 1.439 million at fiscal year-end 2013. Creative ARR was $1.40 billion, Document Services ARR was $217 million, and total Digital Media ARR was $1.62 billion, up 72% from $944 million at fiscal year-end 2013.
- Adobe Marketing Cloud revenue increased 14% in Q3. Management expects approximately 75% of AEM and Adobe Campaign contracts to be term-based during fiscal 2014, compared with approximately 45% in fiscal 2013. The faster transition is expected to shift approximately $60 million of revenue from fiscal 2014 into future periods because term-based revenue is recognized ratably.
- Management believes existing cash, investments, operating cash flow and available credit will be sufficient for working capital and operating requirements for the next twelve months. Adobe intends to refinance the $600 million of 3.25% senior notes due February 1, 2015.
- Adobe entered into interest-rate swaps on the $900 million of 2020 Notes, effectively converting the fixed rate to LIBOR plus a fixed spread. A hypothetical 50-basis-point rate movement was not expected to have a significant effect on results.
- Restructuring plans were substantially complete. Accrued restructuring obligations were $8.1 million, with facility-related obligations payable through fiscal 2021.
- The High-Tech Employee Antitrust Litigation settlement was rejected by the court on August 8, 2014, and trial was scheduled for January 2015. Adobe had accrued a $10.0 million loss contingency.
- Key risks include execution of the subscription and cloud transition, customer renewal rates, delayed revenue recognition, competition and pricing pressure, cybersecurity and service interruptions, privacy regulation, foreign currency exposure, intellectual-property litigation, tax examinations, acquisitions, and potential impairment of goodwill or intangible assets.
- The FASB’s new revenue standard, ASU 2014-09, becomes effective for Adobe in the first quarter of fiscal 2018. Adobe had not selected a transition method and was evaluating the impact.
Most important facts for investors to verify
- Whether Creative Cloud subscription growth, ARR expansion and renewal rates offset the continuing decline in perpetual product revenue.
- Whether the accelerated shift to term-based AEM and Adobe Campaign contracts produces the expected long-term growth despite the approximately $60 million fiscal-year revenue deferral.
- Adobe’s refinancing plans and liquidity position before the $600 million 2015 Notes mature.
- The effect of higher hosting, infrastructure, compensation and stock-based compensation costs on future operating margins.
- The outcome and potential additional exposure from the High-Tech Employee Antitrust Litigation and other intellectual-property or legal matters.
- The effect of tax-rate changes, expiration of tax credits, foreign earnings repatriation and tax examinations on future earnings and cash taxes.
- Potential impacts of cybersecurity incidents, cloud-service outages, privacy regulation and foreign currency movements on revenue, margins and customer retention.