Adobe Systems Incorporated — Q1 Fiscal 2011 Form 10-Q
Business context and reporting period
Adobe develops and markets creative, digital media, document, enterprise, online marketing and related software and services. The filing covers the three months ended March 4, 2011, compared with the three months ended March 5, 2010. Fiscal 2011 has 52 weeks, while the comparable fiscal 2010 quarter included an additional week that increased prior-year revenue by approximately $35 million and expenses by approximately $20 million.
Adobe reorganized its reportable segments beginning in fiscal 2011: Creative and Interactive Solutions, Digital Media Solutions, Knowledge Worker, Enterprise, Omniture, and Print and Publishing. Prior-period segment data was reclassified.
Financial performance and liquidity
| Metric | Q1 FY2011 | Q1 FY2010 | Change |
|---|---|---|---|
| Total revenue | $1,027.7 million | $858.7 million | 20% |
| Gross profit | $920.1 million | $769.3 million | 20% |
| Gross margin | 89.5% | 89.6% | Down slightly |
| Operating income | $302.3 million | $176.8 million | 71% |
| Operating margin | 29.4% | 20.6% | Up substantially |
| Net income | $234.6 million | $127.2 million | 84% |
| Diluted EPS | $0.46 | $0.24 | 92% |
| Cash flow from operations | $332.1 million | $259.9 million | 28% |
- Revenue mix: products $842.7 million, subscription $106.2 million, and services and support $78.8 million. Product revenue increased 20%, subscription revenue 11%, and services and support revenue 33%.
- Segment growth was strongest in Enterprise at 33% and Creative and Interactive Solutions at 28%. Digital Media Solutions and Omniture each grew 16%, Knowledge Worker grew 10%, and Print and Publishing declined 2%.
- Reported gross margin was approximately 90%. Operating expenses increased only 4% despite revenue growth, helped by the absence of significant prior-year restructuring charges and lower amortization of purchased intangibles.
- The effective tax rate declined to 18.0% from 23.5%, primarily reflecting reinstatement of the federal research and development tax credit and stronger forecasted international profits. A $15.2 million prior-year tax-credit benefit was recorded in the quarter.
- Cash and cash equivalents were $900.2 million at March 4, 2011, and short-term investments were $1.7367 billion, for combined cash and short-term investments of approximately $2.637 billion.
- Working capital was $2.3653 billion, compared with $2.1480 billion at December 3, 2010. Total assets were $8.310 billion and stockholders’ equity was $5.425 billion.
- Net cash used in investing activities was $95.1 million, including $36.6 million for the Demdex acquisition and $32.4 million for property and equipment. Financing activities used $86.5 million, primarily for stock repurchases.
- Total debt and capital lease obligations were $1.520 billion, including $1.494 billion of senior notes and $26.3 million of capital lease obligations. The $1.0 billion revolving credit facility was undrawn and fully available.
Material changes versus the prior comparable period
- Revenue benefited from continued adoption of Creative Suite 5, Acrobat X, the Day Software acquisition, and growth in Customer Experience Management and Online Marketing offerings.
- Creative Suite-related revenue increased 38%, and Photoshop point-product revenue increased 14% year over year.
- Operating income and margin improved materially because revenue grew faster than operating expenses, restructuring charges declined from $11.6 million to an immaterial amount, and purchased-intangible amortization declined 44%.
- Interest expense increased to $17.0 million from $7.7 million because of the $1.5 billion senior-notes issuance completed in February 2010.
- Investment results improved to a $1.6 million gain from a $3.5 million loss, while foreign-exchange losses contributed to interest and other expense.
- Adobe completed the Demdex acquisition on January 18, 2011; management stated that its impact was not material to consolidated results. Goodwill increased to $3.686 billion from $3.642 billion.
- Adobe repurchased approximately 2.5 million shares for $125.0 million at an average price of $32.84. The company subsequently committed an additional $420.0 million to a structured repurchase agreement after quarter-end; $455.0 million remained under the repurchase authorization after that transaction.
Guidance, outlook, commentary, risks and unusual items
- Management described the quarter as a record-revenue quarter and stated that growth was driven by Content Authoring, Customer Experience Management and Online Marketing.
- No specific numerical full-year or next-quarter guidance is provided in the filing text. Management stated that existing cash, investments, expected operating cash flow and available credit were sufficient for working-capital and operating requirements for the next twelve months.
- Management expected continued investment in research and development, international operations, facilities, computer systems, acquisitions, strategic investments and stock repurchases.
- Management expected near-term adverse effects on Japanese operating results from the earthquakes and related events occurring after the quarter-end.
- Key risks include dependence on successful new-product development and product transitions, intense competition, changing software delivery and subscription models, privacy and data-security requirements, service interruptions, foreign-currency volatility, global economic conditions, acquisition integration, intellectual-property litigation, distributor concentration and cybersecurity threats.
- Ingram Micro represented 14% of first-quarter net revenue, although no individual distribution agreement exceeded 10% of total revenue.
- Adobe had $163.5 million of gross unrecognized tax benefits, excluding interest and penalties, plus approximately $15.2 million of accrued interest and penalties. Potential reductions in unrecognized tax benefits within the next twelve months were estimated at $0 to approximately $5 million.
- The Eolas patent litigation remained unresolved, with no loss accrued because management determined that a loss was not probable or estimable. Other litigation and indemnification exposures could adversely affect results, although historical indemnification costs were not significant.
- Accrued restructuring liabilities totaled approximately $14.1 million at quarter-end, with facility-related obligations extending through fiscal 2021.
- Management concluded that disclosure controls were effective at a reasonable-assurance level and reported no material changes in internal control over financial reporting during the quarter.
Most important facts for investors to verify
- Whether revenue growth remains durable after adjusting for the prior-year extra week and the benefit from CS5, Acrobat X and acquired businesses.
- The sustainability of the approximately 29% operating margin as product-launch spending, headcount and investments in enterprise and subscription offerings increase.
- Adoption, renewal and profitability trends for Omniture, Enterprise and other subscription or hosted services.
- Execution and integration risks related to Day Software and Demdex, including goodwill and acquired-intangible impairment exposure.
- Cash deployment, including the $420.0 million post-quarter-end structured stock repurchase and the remaining repurchase authorization.
- Debt-service requirements, covenant compliance and the effect of the senior notes on future interest expense and financial flexibility.
- Potential tax-audit outcomes, including transfer-pricing matters and the $163.5 million unrecognized-tax-benefit balance.
- Effects of the Japan earthquake-related disruption, foreign-currency movements and the company’s hedging program.
- Developments in the Eolas patent case and other intellectual-property, privacy, cybersecurity and indemnification matters.