Adobe Systems Incorporated Form 10-Q Summary
Business context and reporting period
Adobe Systems Incorporated, a global software and services company serving creative professionals, knowledge workers, enterprises, marketers and consumers, filed this unaudited Form 10-Q for the quarter ended September 2, 2011. The filing covers the three and nine months ended September 2, 2011, compared with September 3, 2010. Fiscal 2011 has 52 weeks versus 53 weeks in fiscal 2010; the prior-year nine-month period included an additional week.
Reportable segments were Creative and Interactive Solutions, Digital Media Solutions, Knowledge Worker, Enterprise, Omniture, and Print and Publishing. Adobe acquired EchoSign during the quarter and Demdex earlier in fiscal 2011; both acquisitions were not material to consolidated results. Day Software, acquired in October 2010, contributed to Enterprise results.
Financial performance and liquidity
| Metric | Q3 FY2011 | Q3 FY2010 | Change |
|---|---|---|---|
| Revenue | $1,013.2 million | $990.3 million | 2% |
| Gross profit | $908.6 million | $891.2 million | 2% |
| Gross margin | 89.7% | 90.0% | Down 0.3 points |
| Operating income | $274.1 million | $302.0 million | Down 9% |
| Operating margin | 27.0% | 30.5% | Down 3.5 points |
| Net income | $195.1 million | $230.1 million | Down 15% |
| Diluted EPS | $0.39 | $0.44 | Down $0.05 |
| Metric | Nine months FY2011 | Nine months FY2010 | Change |
|---|---|---|---|
| Revenue | $3,064.1 million | $2,792.1 million | 10% |
| Gross profit | $2,742.6 million | $2,495.8 million | 10% |
| Gross margin | 89.5% | 89.4% | Up 0.1 points |
| Operating income | $853.2 million | $706.1 million | 21% |
| Operating margin | 27.8% | 25.3% | Up 2.5 points |
| Net income | $659.1 million | $505.8 million | 30% |
| Diluted EPS | $1.30 | $0.95 | Up $0.35 |
- Revenue mix shifted toward recurring and service activities. Q3 product revenue declined 2%, while subscription revenue increased 13% and services and support revenue increased 38%. For the nine-month period, product revenue increased 7%, subscription revenue 14%, and services and support 41%.
- Q3 revenue growth was led by Omniture, up 18%, Knowledge Worker, up 7%, and Enterprise, up 2%. Digital Media Solutions declined 4% and Print and Publishing declined 7%. Creative and Interactive Solutions was essentially flat year over year in the quarter. For nine months, Omniture increased 20%, Enterprise 22%, Knowledge Worker 11%, and Creative and Interactive Solutions 9%.
- Q3 operating expenses increased 8%, principally from higher headcount, sales commissions, bonuses, marketing spending and research and development investment. Amortization of purchased intangibles declined 41% in the quarter and 42% year to date as older Macromedia-related assets were fully amortized.
- Net cash provided by operating activities was $1,046.6 million for the nine months, compared with $802.4 million in the prior-year period. Cash flow benefited from higher net income and deferred revenue, partly offset by lower accrued expenses and taxes payable.
- Investing cash outflow was $497.7 million, including acquisitions, capital expenditures of $135.4 million and net purchases of investments. Financing cash outflow was $550.2 million, primarily from $695.0 million of treasury-stock repurchases.
- Cash and cash equivalents were $769.2 million at September 2, 2011, and short-term investments were $1,950.1 million, for total cash, cash equivalents and short-term investments of approximately $2.7 billion. Working capital was $2.4 billion.
- Total debt and capital lease obligations were $1,516.4 million, including approximately $1.5 billion of senior notes and $21.9 million of capital lease obligations. The $1.0 billion revolving credit facility was undrawn and fully available. Adobe reported compliance with its debt and lease covenants.
Material changes versus the prior comparable period
- Quarterly profitability declined despite modest revenue growth because operating expenses grew faster than revenue and non-operating expense increased to $17.4 million from $5.3 million. Foreign exchange losses and higher interest expense were significant factors.
- Nine-month profitability improved substantially, aided by revenue growth, lower restructuring charges, lower purchased-intangible amortization, and a lower effective tax rate.
- The nine-month effective tax rate decreased to 18% from 23%, primarily because of a favorable state tax ruling and reinstatement of the federal research and development tax credit. The quarterly effective tax rate increased to 24% from 23%, partly because of a one-time tax charge related to EchoSign intercompany transactions.
- Adobe repurchased approximately 19.8 million shares for $695.0 million during the nine months, compared with approximately 19.0 million shares for $650.0 million in the prior-year period. The company had approximately $355.5 million remaining under the repurchase authority at quarter-end.
- Goodwill increased to $3.74 billion from $3.64 billion at December 3, 2010, primarily due to the Demdex and EchoSign acquisitions and foreign-currency translation. Deferred revenue increased to $484.1 million from $429.7 million.
Guidance, outlook, commentary, risks and unusual items
The filing does not provide a clear numerical quarterly or full-year revenue or earnings guidance figure. Management stated that it would continue investing in research and development, international operations, facilities, technology infrastructure and strategic acquisitions. Management believed existing cash, investments, operating cash flow and available credit were sufficient to meet working-capital and operating requirements for the next twelve months.
- Management cited continued adoption of Creative Suite 5.5, Acrobat X, Day content-management solutions and the Adobe Online Marketing Suite as growth drivers. Print and Publishing was pressured by the nonrecurrence of a large prior-year Captivate and Tech Communication transaction.
- Restructuring liabilities totaled approximately $14.7 million at quarter-end, with facility-related obligations expected to be paid through fiscal 2021. Fiscal 2011 restructuring charges were $3.3 million for nine months.
- Unrecognized tax benefits were $141.0 million, excluding interest and penalties. A Canadian tax examination resulted in approximately $35 million of accrued tax and interest being reclassified, with approximately $17 million expected to be paid by the first quarter of fiscal 2012. Potential future reductions in unrecognized tax benefits were estimated at $0 to $25 million, but timing remained uncertain.
- Adobe faced an Eolas patent-infringement lawsuit scheduled for trial in February 2012. No provision was recorded because management did not believe a loss was probable or estimable. The filing states that adverse outcomes in this or other intellectual-property matters could affect financial results.
- Key disclosed risks included rapid technological change, competition and pricing pressure, dependence on successful product releases and new cloud or subscription models, privacy and data-security obligations, foreign-currency volatility, global economic conditions, acquisition integration, intellectual-property litigation, distributor concentration, debt service, tax examinations and potential goodwill or intangible-asset impairment.
- Ingram Micro represented 13% of third-quarter net revenue, although no individual agreement with that distributor exceeded 10% of total revenue.
- Subsequent to September 2, 2011, Adobe completed two asset acquisitions and two business combinations with aggregate consideration of approximately $91 million; management did not expect a material consolidated impact.
Investor verification checklist
- Verify the sustainability of growth in subscription, services, Omniture and Enterprise revenue as Adobe transitions from perpetual product licensing toward recurring and hosted models.
- Assess whether operating-expense growth, particularly sales and marketing and research and development, is translating into sufficient future revenue and margin expansion.
- Review the effect of foreign-currency movements and hedging on reported revenue, operating results and cash flow.
- Evaluate liquidity after debt service, share repurchases, acquisitions, capital expenditures and potential tax payments, including the $1.0 billion undrawn credit facility.
- Monitor the Eolas litigation, other intellectual-property claims, tax examinations and the potential range of unrecognized-tax-benefit settlements.
- Reconcile segment trends using the revised fiscal 2011 segment presentation and account for the extra week included in the prior-year comparison.
- Review goodwill and acquired-intangible balances for impairment risk and confirm the expected financial contribution from Day, EchoSign and other acquisitions.