Adobe Systems Incorporated Form 10-Q Summary
Business context and reporting period
Quarterly report for the period ended August 30, 2013, covering Adobe’s third quarter and first nine months of fiscal 2013. Adobe operates across Digital Media, Digital Marketing, and Print and Publishing. The company is transitioning from perpetual software licenses to subscription and cloud-based offerings, principally Creative Cloud and Adobe Marketing Cloud.
Financial performance and liquidity
| Metric | Q3 FY2013 | Q3 FY2012 | Change |
|---|---|---|---|
| Revenue | $995.1 million | $1,080.6 million | Down 8% |
| Gross profit | $848.0 million | $961.0 million | Down 12% |
| Gross margin | 85.2% | 88.9% | Down 3.7 points |
| Operating income | $110.4 million | $278.3 million | Down 60% |
| Operating margin | 11.1% | 25.8% | Down 14.7 points |
| Net income | $83.0 million | $201.4 million | Down 59% |
| Diluted EPS | $0.16 | $0.40 | Down 60% |
For the first nine months, revenue was $3.014 billion versus $3.250 billion, gross profit was $2.575 billion versus $2.891 billion, operating income was $319.9 million versus $872.4 million, and net income was $224.7 million versus $610.4 million. Gross margin was approximately 85.4% versus 89.0%; operating margin was 10.6% versus 26.8%; and net margin was 7.5% versus 18.8%.
- Q3 revenue mix: products $582.2 million, subscription $299.3 million, and services and support $113.6 million. Subscription revenue increased 73% and represented 30% of total revenue, versus 16% in the prior-year quarter.
- Digital Media revenue declined 16% to $636.7 million, primarily from the migration of perpetual Creative products to Creative Cloud and enterprise term license agreements.
- Digital Marketing revenue increased 18% to $311.7 million. Adobe Marketing Cloud revenue increased 28% year over year in the quarter.
- Print and Publishing revenue declined 14% to $46.7 million.
- Net cash provided by operating activities for the first nine months was $836.7 million, down from $1.026 billion. Net cash used in investing was $1.178 billion, including acquisitions and investment purchases; net cash used in financing was $258.6 million.
- Cash and cash equivalents were $819.1 million at August 30, 2013, compared with $1.425 billion at November 30, 2012. Short-term investments were $2.345 billion, producing total cash, cash equivalents, and short-term investments of $3.164 billion.
- Total debt and capital lease obligations were approximately $1.520 billion, including $1.5 billion of senior notes and $24.0 million of capital lease obligations. The $1.0 billion revolving credit facility was undrawn, and Adobe reported compliance with its covenants.
- Deferred revenue was $734.1 million, up $114.5 million, or 18%, from November 30, 2012.
Material changes versus the prior comparable period
- The subscription transition materially reduced recognized product revenue and near-term profitability because perpetual license revenue is recognized upfront while subscription revenue is recognized ratably.
- Operating expenses increased 8% in Q3 and 12% year to date, primarily from compensation, headcount growth, stock-based compensation, and investment in strategic products and services.
- Cost of revenue increased 23% in Q3, driven by hosting and server costs, personnel, and amortization associated with subscription and SaaS offerings.
- Creative Cloud adoption accelerated. Adobe exited the quarter with 1.031 million paid Creative Cloud subscriptions and Digital Media annualized recurring revenue of $655.0 million, compared with $203.0 million at November 30, 2012.
- Adobe completed the acquisition of Neolane on July 22, 2013, for a preliminary purchase price of approximately $616.5 million, principally adding cross-channel campaign management capabilities to Digital Marketing. The acquisition’s reported financial impact was not material.
- Goodwill increased to $4.752 billion from $4.133 billion, primarily due to the Behance and Neolane acquisitions. The annual goodwill impairment test identified no impairment.
- Adobe recorded a $23.8 million write-down on Waltham, Massachusetts property assets classified as held for sale. The property was sold in September 2013 for net proceeds of $24.3 million, approximately equal to its carrying value.
- Adobe repurchased approximately 13.7 million shares for $700.0 million during the first nine months and 7.044 million shares during the quarter. A further $400.0 million structured repurchase prepayment was made after quarter-end.
Guidance, outlook, commentary, risks, and unusual items
Management expects the shift to Creative Cloud and other subscription offerings to cause traditional perpetual-license revenue and near-term total revenue, operating margin, and net income to decline during the transition. Management expects the model to increase recurring and predictable revenue and support higher long-term growth by attracting new users and keeping customers current.
- Management stated that expenses are not expected to decline in line with the reduction in perpetual-license revenue during fiscal 2013.
- Future AEM and Adobe Marketing Cloud growth may be affected as revenue shifts from upfront license recognition to ratable managed-services recognition.
- Key risks include failure to achieve subscription adoption, renewal, pricing, and customer retention targets; increased cloud infrastructure costs; intense competition; foreign exchange exposure; acquisition integration; intellectual property disputes; tax uncertainty; and potential goodwill or intangible-asset impairment.
- In September 2013, Adobe disclosed sophisticated attacks involving unauthorized access to certain customer and product information. Adobe stated that it did not then believe the incident would have a material adverse effect, but acknowledged potential adverse effects involving security, privacy, litigation, regulatory, reputational, and operating risks.
- Adobe reported $126.9 million of gross unrecognized tax benefits, excluding interest and penalties, and approximately $9.4 million of accrued interest and penalties. A completed 2008–2009 U.S. tax examination generated a $7.2 million tax benefit in Q3.
- Restructuring liabilities were approximately $12.1 million at quarter-end, with certain facility obligations payable through fiscal 2021.
- Adobe’s stated liquidity assessment is that existing cash, investments, operating cash flow, and available credit are sufficient for working-capital and operating requirements over the next twelve months.
Most important facts for investors to verify
- Whether Creative Cloud subscription growth, annualized recurring revenue, and renewal rates offset declining perpetual-license revenue.
- The effect of ratable revenue recognition on future reported revenue, cash flow, gross margin, and operating margin.
- Integration progress and returns from Neolane and other acquisitions, including the effect of goodwill and acquired-intangible amortization.
- Financial and legal consequences of the September 2013 security incident, including customer notification, remediation costs, claims, regulatory action, and reputational impact.
- Future cash deployment among acquisitions, investments, capital expenditures, debt service, and the $2.0 billion stock-repurchase authorization.
- Exposure to foreign currency movements, tax examinations, intellectual property claims, subscription cancellations, and cloud-service availability or security failures.