Adobe Systems Incorporated — Fiscal 2017 Q3 Form 10-Q
Reporting period: Three and nine months ended September 1, 2017, compared with September 2, 2016. Adobe provides digital media, digital marketing and print and publishing products, increasingly through subscription and cloud-based models.
Financial performance
| Metric | Q3 FY2017 | Q3 FY2016 | 9M FY2017 | 9M FY2016 |
|---|---|---|---|---|
| Revenue | $1.841 billion | $1.464 billion | $5.295 billion | $4.246 billion |
| Gross profit | $1.578 billion | $1.261 billion | $4.555 billion | $3.643 billion |
| Operating income | $545.7 million | $369.3 million | $1.519 billion | $1.021 billion |
| Net income | $419.6 million | $270.8 million | $1.192 billion | $769.2 million |
| Diluted EPS | $0.84 | $0.54 | $2.38 | $1.52 |
| Operating cash flow | Not separately provided | Not separately provided | $2.080 billion | $1.504 billion |
- Q3 revenue increased 26%; nine-month revenue increased 25%. Subscription revenue grew 34% in both periods and represented 85% of Q3 revenue and 84% of nine-month revenue.
- Q3 gross margin was approximately 85.7%, operating margin 29.6% and net margin 22.8%. Nine-month margins were approximately 86.0%, 28.7% and 22.5%, respectively.
- Digital Media revenue increased 28% in Q3 and 26% year to date; Digital Marketing increased 23% and 24%, respectively. Print and Publishing declined 7% in Q3 and 4% year to date.
- Digital Media annualized recurring revenue reached $4.87 billion, up from $3.99 billion at fiscal 2016 year-end. Creative ARR was $4.32 billion and Document Cloud ARR was $556 million.
- Adobe Experience Cloud revenue was $507.8 million in Q3, up 26% year over year. Management noted pressure on future growth from larger deal sizes and longer sales cycles.
Liquidity, cash flow and capital structure
- At September 1, 2017, cash and cash equivalents were $1.775 billion and short-term investments were $3.594 billion, for total cash and short-term investments of approximately $5.368 billion.
- Working capital was $3.365 billion, compared with $3.028 billion at December 2, 2016.
- Nine-month operating cash flow increased 38% to $2.080 billion. Investing cash flow was an outflow of $463.3 million, including $459.6 million for acquisitions and $140.4 million for property and equipment. Financing cash flow was an outflow of $864.2 million, primarily reflecting $800 million of treasury-stock purchases.
- Debt had a carrying value of $1.889 billion and consisted 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 was in compliance with its covenants.
- Adobe repurchased approximately 6.3 million shares during the nine-month period at an average price of $126.58. Approximately $2.299 billion remained under the authorized repurchase program at September 1, 2017; a subsequent $300 million structured repurchase prepayment reduced remaining authority to approximately $1.9 billion.
Material changes and unusual items
- Adobe completed its $560.8 million TubeMogul acquisition in December 2016 and integrated it into Digital Marketing. The transaction contributed to Advertising Cloud growth and increased goodwill to $5.821 billion from $5.406 billion at fiscal 2016 year-end.
- Operating expenses increased 16% in both Q3 and the first nine months, primarily due to higher headcount, compensation and stock-based compensation. Nine-month stock-based compensation expense was $334.7 million, compared with $262.6 million in the prior period.
- Cost of revenue increased 30% in Q3 and 23% year to date, driven principally by higher royalty costs, media costs related to Advertising Cloud, and increased personnel and infrastructure costs.
- Adobe early adopted the employee share-based payment accounting standard in fiscal 2017. Excess tax benefits are now recognized in income tax expense and operating cash flow; the change reduced the effective tax rate by approximately one percentage point.
- Adobe exercised its option to purchase the Almaden Tower for $103.6 million, capitalizing approximately $104.2 million of property and equipment and applying an $80.4 million lease receivable against the purchase price.
- Deferred revenue was approximately $2.205 billion at September 1, 2017, up 9% from December 2, 2016, primarily reflecting growth in Creative Cloud and Experience Cloud contracts and renewals.
Outlook, risks and contingencies
- Management believes existing cash, investments, operating cash flows and available credit will be sufficient for working capital and operating requirements over the next twelve months. The filing does not provide a specific quantitative revenue or earnings forecast.
- Key risks include subscription renewal rates, longer enterprise sales cycles, competitive pressure, customer adoption of new products and platforms, cybersecurity and hosted-service interruptions, privacy and data-transfer regulation, foreign currency movements, intellectual-property claims, acquisition integration and potential goodwill impairment.
- Foreign currency movements reduced reported revenue by approximately $11.1 million in Q3 and $10.6 million for the first nine months after hedging effects.
- Gross unrecognized tax benefits were $175.7 million, with accrued interest and penalties of $22.0 million. Potential decreases in unrecognized tax benefits within twelve months were estimated at $0 to approximately $40 million.
- Adobe disclosed intellectual-property, customer indemnification and ordinary-course legal risks but recorded no additional material litigation provision based on the information available at filing.
- The company stated that disclosure controls and procedures were effective at the reasonable assurance level and that no material changes affected internal control over financial reporting during the quarter.
Investor verification checklist
- Verify the sustainability of subscription growth, ARR expansion and renewal rates, particularly in Creative Cloud and Document Cloud.
- Assess whether larger deal sizes and longer sales cycles continue to pressure Experience Cloud growth and bookings.
- Reconcile reported operating cash flow with deferred revenue, accrued media costs and other working-capital movements.
- Monitor TubeMogul integration, Advertising Cloud profitability, goodwill and acquired-intangible carrying values.
- Review the impact of the forthcoming revenue-recognition and lease accounting standards on reported revenue, deferred revenue and balance-sheet presentation.
- Evaluate exposure to cybersecurity, privacy regulation, foreign exchange, intellectual-property disputes and tax examinations.