Adobe Systems Incorporated: Fiscal 2016 Third-Quarter Form 10-Q
Business context and reporting period
The filing covers the three and nine months ended September 2, 2016, compared with August 28, 2015. Adobe provides creative, document, digital marketing, publishing and related cloud-based software and services through its Digital Media, Digital Marketing, and Print and Publishing segments. Fiscal 2016 is a 53-week year; the nine-month period benefited from an additional week in the first quarter.
Financial performance and liquidity
| Metric | Three months ended September 2, 2016 | Year-over-year change | Nine months ended September 2, 2016 | Year-over-year change |
|---|---|---|---|---|
| Total revenue | $1,464.0 million | 20% | $4,246.0 million | 22% |
| Subscription revenue | $1,168.6 million | 41% | $3,322.5 million | 43% |
| Gross profit | $1,261.3 million | 23% | $3,642.7 million | 24% |
| Operating income | $369.3 million | 50% | $1,021.3 million | 67% |
| Net income | $270.8 million | 55% | $769.2 million | 89% |
| Diluted earnings per share | $0.54 | 59% | $1.52 | 90% |
| Cash flow from operations | Not separately reported | Not applicable | $1,504.1 million | 48% |
Reported third-quarter gross margin was approximately 86.1%, operating margin 25.2%, and net margin 18.5%. Nine-month gross margin was approximately 85.8%, operating margin 24.1%, and net margin 18.1%.
- Segment revenue: Digital Media revenue was $990.0 million, up 29%; Digital Marketing was $429.6 million, up 7%; and Print and Publishing was $44.4 million, down 3%.
- Recurring revenue indicators: Digital Media annualized recurring revenue reached $3.70 billion, up from $2.88 billion at fiscal 2015 year-end. Creative ARR was $3.26 billion and Document Cloud ARR was $442 million.
- Deferred revenue: Total deferred revenue was approximately $1.80 billion at September 2, 2016, up 21% from fiscal year-end, primarily reflecting growth in Creative Cloud and Adobe Marketing Cloud contracts.
- Cash and investments: Cash and cash equivalents were $767.7 million, and short-term investments were $3.679 billion. Working capital was $2.913 billion.
- Debt and liquidity: Debt carrying value was $1.917 billion, consisting primarily of $900 million of 2020 senior notes and $1.0 billion of 2025 senior notes. The $1.0 billion revolving credit facility was undrawn, and management stated that available liquidity and expected operating cash flow were sufficient for the next twelve months.
- Capital allocation: Adobe used $775.0 million for treasury-stock repurchases during the nine months. Approximately 7.3 million shares were repurchased at an average price of $93.87. Following a subsequent $300 million structured repurchase, $500 million remained under the program authority.
Material changes versus the prior comparable periods
- The business continued its transition from perpetual licenses to subscriptions. Subscription revenue increased from 68% to 80% of third-quarter revenue and from 66% to 78% of nine-month revenue.
- Product revenue declined 34% in the quarter and 31% year to date, reflecting the shift away from perpetual licensing.
- Digital Media growth was led by Creative Cloud subscriptions, paid-seat growth, enterprise term license agreements and Adobe Stock. Creative revenue grew 39% year over year to $802.7 million.
- Document Cloud revenue declined slightly to $187.3 million as Acrobat perpetual-license revenue declined during the subscription transition.
- Operating expenses increased 14% in the quarter and 12% year to date, principally due to higher compensation and benefits from increased headcount, while operating income grew faster than revenue.
- The effective tax rate decreased to 24% for the quarter and 21% for the nine months, compared with 25% and 29%, respectively, primarily due to U.S. research and development tax-credit benefits and prior-year discrete tax items.
- Operating cash flow increased substantially, supported by higher net income and a $308.1 million increase in deferred revenue. Investing cash outflows were primarily purchases of short-term investments, while financing outflows were driven by share repurchases.
Guidance, outlook, commentary, risks and unusual items
- Management highlighted continued execution in Digital Media and Digital Marketing and stated that it expected continued demand for Adobe Marketing Cloud to support future revenue growth. The filing does not provide a clear consolidated quantitative revenue or earnings forecast.
- Management expects continued investment in research and development, cloud operations, facilities, strategic acquisitions and technology infrastructure.
- Key risks include subscription-renewal rates, customer acceptance of cloud delivery and pricing, extended enterprise sales cycles, competition, cybersecurity and service interruptions, privacy and data-transfer regulation, foreign-exchange exposure, intellectual-property litigation, tax examinations and acquisition integration.
- Foreign currency movements reduced reported revenue by approximately $10.3 million in the quarter and $73.3 million year to date, after hedging effects.
- The filing reports an immaterial other-than-temporary impairment on certain cost-method investments, an immaterial acquisition, and no goodwill impairment.
- Unrecognized tax benefits totaled $271.9 million, excluding interest and penalties. Accrued interest and penalties were $35.1 million; the filing estimates potential decreases in unrecognized tax benefits within the next twelve months could range from zero to approximately $10.0 million.
- Adobe reported compliance with its debt, revolving-credit and Almaden Tower lease covenants. The Almaden Tower lease includes a $89.4 million residual-value guarantee and an option to purchase the building for $103.6 million.
- Disclosure controls and procedures were deemed effective, with no material changes to internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether Creative Cloud and Document Cloud ARR growth continues to convert into sustainable revenue and cash-flow growth.
- Subscription renewal rates, customer acquisition costs, pricing, promotional activity and the pace of perpetual-license revenue declines.
- Digital Marketing bookings, contract duration, implementation timing and Adobe Marketing Cloud growth by product.
- The impact of foreign exchange, cloud infrastructure costs, headcount growth and stock-based compensation on future margins.
- Cash availability after structured repurchases, the remaining repurchase authorization, and the timing and terms of any future capital allocation.
- Potential effects of tax examinations, unrecognized tax benefits and future accounting standards for revenue recognition, leases and share-based payments.
- Exposure to cybersecurity incidents, service outages, privacy regulation, intellectual-property claims and other contingencies described in the risk factors.