Adobe Systems Incorporated — Q3 FY2012 Form 10-Q Summary
Business context and reporting period
Adobe develops software and services for digital media, digital marketing, document services, publishing, and related content and experience workflows. This unaudited Form 10-Q covers the three and nine months ended August 31, 2012, compared with September 2, 2011. Fiscal 2012 reporting emphasizes the Digital Media and Digital Marketing segments, while Print and Publishing remains a mature-product segment.
Adobe launched Creative Suite 6 and the subscription-based Creative Cloud in May 2012. Management expects the transition from perpetual licenses to subscriptions to increase recurring and predictable revenue over time, but also to defer revenue recognition and reduce traditional perpetual-license revenue during the transition.
Financial performance and liquidity
| Metric | Q3 FY2012 | Q3 FY2011 | Change |
|---|---|---|---|
| Revenue | $1,080.6 million | $1,013.2 million | 7% |
| Gross profit | $961.0 million | $908.6 million | 6% |
| Gross margin | 89.0% | 89.7% | Down approximately 0.7 percentage points |
| Operating income | $278.3 million | $274.1 million | 2% |
| Operating margin | 25.8% | 27.0% | Down approximately 1.2 percentage points |
| Net income | $201.4 million | $195.1 million | 3% |
| Diluted EPS | $0.40 | $0.39 | 3% |
| Metric | First nine months FY2012 | First nine months FY2011 | Change |
|---|---|---|---|
| Revenue | $3,250.2 million | $3,064.1 million | 6% |
| Operating income | $872.4 million | $853.2 million | 2% |
| Operating margin | 26.8% | 27.8% | Down approximately 1.0 percentage point |
| Net income | $610.4 million | $659.1 million | Down 7% |
| Diluted EPS | $1.22 | $1.30 | Down 6% |
| Cash flow from operations | $1,025.9 million | $1,046.6 million | Down 2% |
Q3 revenue comprised products of $810.5 million, subscription revenue of $172.9 million, and services and support revenue of $97.2 million. Subscription revenue increased 51% year over year in Q3 and 45% for the first nine months. Subscription revenue represented 16% of Q3 revenue, versus 11% in the prior-year quarter.
At August 31, 2012, Adobe had cash and cash equivalents of $1.162 billion, short-term investments of $2.085 billion, working capital of $2.841 billion, and total stockholders' equity of $6.439 billion. Total cash, cash equivalents, and short-term investments were approximately $3.247 billion.
Cash flow from operations was $1.026 billion for the first nine months. Investing cash outflows were $705.2 million, including $353.2 million for acquisitions and $189.3 million for property and equipment. Financing cash outflows were $154.3 million, including $305.0 million of treasury-stock purchases, partly offset by $150.2 million from treasury-stock issuances.
Debt consisted primarily of $600 million of 3.25% senior notes due 2015 and $900 million of 4.75% senior notes due 2020. The company had no borrowings under its new $1.0 billion revolving credit facility, and all stated debt and lease covenants were satisfied. Capital lease obligations totaled $15.8 million.
Material changes versus the prior comparable period
- Digital Media revenue increased 3% in both Q3 and the first nine months, supported by CS6, Photoshop, Lightroom 4, Acrobat, and Document Exchange Services. Creative Cloud adoption was higher than expected and contributed approximately $12.0 million of subscription revenue since its May launch.
- Digital Marketing revenue increased 21% in Q3 and 20% year to date. Digital Marketing Suite revenue increased 40% in Q3 and 36% year to date, helped by Web Experience Management and Efficient Frontier. LiveCycle revenue declined.
- Print and Publishing revenue declined 2% in Q3 and increased 1% year to date, reflecting lower legacy-product revenue offset by consulting fees and PostScript royalties.
- Revenue growth was strongest in the Americas and APAC; EMEA was broadly stable in U.S.-dollar terms because of economic conditions and currency weakness. Net foreign-exchange effects on revenue were immaterial for the first nine months after hedging.
- Total cost of revenue increased 14% in Q3 and 12% year to date, exceeding revenue growth. Higher subscription hosting, amortization, services headcount, royalties, and reserves for older CS5 and CS5.5 inventory pressured margins.
- Operating expenses increased 8% in Q3 and 7% year to date, led by sales and marketing, general and administrative expense, and amortization of acquired intangibles.
- Year-to-date net income declined despite revenue and operating-income growth, primarily because the effective tax rate increased to 26.3% from 17.8%. The change reflected expiration of the U.S. research and development tax credit and prior-year one-time tax items.
- Goodwill increased to $4.127 billion from $3.849 billion, primarily from the Efficient Frontier acquisition and foreign-currency translation. Adobe reported no goodwill impairment.
Guidance, outlook, commentary, risks, and unusual items
Management expects continued growth in Digital Marketing Suite revenue and subscription revenue, with increasing recurring revenue as Creative Cloud and other hosted offerings expand. The filing does not provide a clear numerical quarterly or full-year revenue or earnings guidance figure.
- The transition to subscriptions may reduce near-term reported revenue and cash received from new sales because revenue is recognized ratably. Renewal rates, pricing, customer adoption, and channel reactions remain important variables.
- Key risks include competition, rapid technology and platform changes, execution of cloud and non-PC strategies, service reliability, cybersecurity and privacy exposure, intellectual-property litigation, foreign-currency movements, global economic weakness, distributor concentration, and acquisition integration.
- Ingram Micro represented 11% of Q3 net revenue, although no individual distribution agreement exceeded 10% of total revenue.
- Restructuring accruals totaled $27.5 million at August 31, 2012. Adobe expects related payments through fiscal 2021, with approximately $5.0 million associated with termination benefits and contract terminations.
- Unrecognized tax benefits totaled $157.9 million, excluding interest and penalties. Management estimated that potential decreases in these benefits during the following 12 months could range from zero to approximately $5 million.
- Adobe prevailed in a June 2012 jury trial involving Tarkus Imaging's patent-infringement claim. The filing continues to caution that other litigation, indemnification claims, or intellectual-property disputes could adversely affect results.
- In April 2012, Adobe authorized a new $2.0 billion stock-repurchase program through fiscal 2015. Subsequent to quarter-end, Adobe prepaid $100 million under a structured repurchase agreement, leaving $1.9 billion of authority.
- Management concluded that disclosure controls were effective as of August 31, 2012, and reported no material changes in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether Creative Cloud adoption produces the expected long-term recurring-revenue growth without causing greater-than-expected near-term revenue, margin, or cash-flow pressure.
- Subscription renewal rates, customer additions, average pricing, deferred revenue trends, and the composition of future product versus subscription revenue.
- Digital Marketing Suite growth and the integration and financial contribution of Efficient Frontier.
- Operating-margin trends as hosting costs, sales and marketing investment, stock-based compensation, and amortization increase.
- The effect of tax-credit expiration, tax audits, unrecognized tax benefits, and potential foreign-earnings repatriation on future tax rates.
- Liquidity after acquisitions, capital expenditures, restructuring payments, debt service, and additional stock repurchases.
- Exposure to cybersecurity, privacy, service outages, intellectual-property claims, distributor concentration, foreign exchange, and economic weakness in Europe.
- The filing's stated $1.0 billion undrawn revolving facility, $1.5 billion senior-note principal balance, covenant compliance, and the timing of future debt maturities.