Adobe Systems Incorporated (now Adobe Inc.) — Fiscal 2018 Second-Quarter 10-Q
Business context and reporting period
The unaudited Form 10-Q covers the three and six months ended June 1, 2018, compared with the periods ended June 2, 2017. Adobe operates primarily through Digital Media, Digital Experience and Publishing, with increasing emphasis on subscription and cloud-based offerings, including Creative Cloud, Document Cloud and Adobe Experience Cloud.
Financial performance and position
| Metric | Three months ended June 1, 2018 | Year-over-year change | Six months ended June 1, 2018 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $2.195 billion | 24% | $4.274 billion | 24% |
| Subscription revenue | $1.923 billion | 30% | $3.716 billion | 30% |
| Gross profit | $1.914 billion | 25% | $3.734 billion | 25% |
| Operating income | $698.5 million | 39% | $1.401 billion | 44% |
| Net income | $663.2 million | 77% | $1.246 billion | 61% |
| Diluted EPS | $1.33 | vs. $0.75 | $2.50 | vs. $1.54 |
- Approximate gross margin was 87.2% for the quarter and 87.4% year to date; operating margin was 31.8% and 32.8%, respectively; net margin was 30.2% and 29.2%, respectively.
- Digital Media revenue was $1.546 billion in the quarter, up 28%; Digital Experience revenue was $586.0 million, up 18%; Publishing revenue was $63.0 million, down 3%.
- Digital Media annualized recurring revenue reached $6.06 billion at quarter-end, up from $5.39 billion at December 1, 2017. Creative ARR was $5.37 billion and Document Cloud ARR was $694 million.
- Operating cash flow for the six months was $1.966 billion, up from $1.375 billion. Investing cash flow was negative $26.1 million and financing cash flow was negative $1.259 billion.
- Cash and cash equivalents were $2.988 billion and short-term investments were $3.346 billion at June 1, 2018. Working capital was $4.013 billion.
- Debt carrying value was $1.874 billion, consisting primarily of $900 million of 4.75% senior notes due 2020 and $1 billion of 3.25% senior notes due 2025. The $1 billion revolving credit facility was undrawn, and Adobe reported compliance with its covenants.
Material changes versus the prior comparable period
- Growth remained concentrated in recurring subscription revenue, which represented 88% of quarterly revenue versus 84% in the prior-year quarter.
- Product revenue declined 12% for the quarter and 9% year to date, consistent with the shift from perpetual licensing toward subscriptions and cloud services.
- Operating expenses increased 18% for the quarter and 16% year to date, driven primarily by higher stock-based compensation, headcount and related compensation costs.
- The effective tax rate declined to 4% for the quarter and 11% year to date, compared with 24% and 19%, respectively, largely due to the Tax Cuts and Jobs Act and changes to Adobe’s corporate tax structure.
- Adobe repurchased approximately 4.3 million shares during the six months at an average price of $208.69 and paid $1.0 billion in structured repurchase prepayments. In May 2018, the board authorized an additional $8 billion repurchase program through fiscal 2021.
Guidance, outlook, commentary and unusual items
- The filing does not provide clear quantitative full-year revenue or earnings guidance. Management described the quarter as strong and cited continued execution in Digital Media and Digital Experience.
- Management expects Creative Cloud, Document Cloud and Experience Cloud adoption to support recurring revenue growth. Adobe reported Creative revenue of $1.30 billion, up 29%, and Document Cloud revenue of $243.0 million, up from $199.9 million.
- Adobe completed the acquisition of Magento Commerce after June 1, 2018 for approximately $1.68 billion in cash, plus assumed employee equity awards. Magento was expected to be integrated into Digital Experience in the third quarter of fiscal 2018; purchase accounting was not complete when the filing was issued.
- The Tax Cuts and Jobs Act produced provisional accounting effects, including a transition tax expense and approximately $489 million of adjusted long-term transition-tax liability. Adobe stated that its tax accounting remained subject to additional guidance and could change materially.
- Adobe expects to adopt the new revenue recognition standard in the first quarter of fiscal 2019 using the modified retrospective method. Annual revenue is not expected to change materially, but adoption may materially affect deferred revenue, retained earnings and contract-cost assets.
- Key risks include subscription renewal and customer acquisition rates, intense competition, cybersecurity and service outages, privacy and data-transfer regulation including GDPR, foreign currency exposure, intellectual-property claims, acquisition integration, tax examinations and potential goodwill or intangible-asset impairment.
- Management stated that existing cash, investments, expected operating cash flow and available credit were sufficient for working-capital and operating requirements for at least the next twelve months.
Important facts for investors to verify
- Reconcile the reported $6.06 billion Digital Media ARR with subsequent renewal, bookings and revenue trends; ARR is a management performance metric and is not equivalent to revenue or deferred revenue.
- Monitor the completion of Magento purchase accounting, acquisition-related costs, integration performance and the effect on Digital Experience growth and margins.
- Assess the sustainability of the unusually low effective tax rate and the remaining provisional Tax Act estimates, transition-tax payments and tax-audit exposures.
- Review the impact of fiscal 2019 revenue-standard adoption on deferred revenue, retained earnings, contract assets and revenue classification.
- Evaluate the scale of stock-based compensation, which totaled approximately $281 million for the six months, and its effect on dilution and operating margins.
- Track subscription renewal rates, customer concentration and enterprise sales-cycle timing, which can delay recognition of changes in demand.
- Review cybersecurity, privacy, intellectual-property, litigation and service-continuity disclosures, as the filing does not quantify the maximum potential exposure for several indemnification and legal matters.