Adobe Systems Incorporated Form 10-Q Summary
Business context and reporting period
Adobe provides software and cloud-based services through its Digital Media, Digital Marketing, and Print and Publishing segments. The filing covers the three and six months ended June 2, 2017, compared with the periods ended June 3, 2016. Fiscal 2016 included an extra week in the first quarter, affecting year-to-date comparability.
Financial performance and key metrics
| Metric | Q2 FY2017 | Q2 FY2016 | Change |
|---|---|---|---|
| Revenue | $1.772 billion | $1.399 billion | 27% |
| Subscription revenue | $1.484 billion | $1.084 billion | 37% |
| Gross profit | $1.533 billion | $1.197 billion | 28% |
| Gross margin | 86.5% | 85.6% | Up approximately 0.9 percentage points |
| Operating income | $504.1 million | $344.2 million | 46% |
| Operating margin | 28.4% | 24.6% | Up approximately 3.8 percentage points |
| Net income | $374.4 million | $244.1 million | 53% |
| Diluted EPS | $0.75 | $0.48 | 56% |
For the six months ended June 2, 2017, revenue was $3.454 billion, up 24%; gross profit was $2.977 billion; operating income was $973.1 million; and net income was $772.8 million, or $1.54 diluted EPS. Year-to-date gross margin was approximately 86.2%, operating margin approximately 28.2%, and net margin approximately 22.4%.
- Digital Media revenue was $1.212 billion in Q2, up 29%; Digital Marketing revenue was $516.7 million, up 25%; Print and Publishing revenue was $43.5 million, essentially flat.
- Creative revenue was approximately $1.01 billion, up 34%, and Adobe Experience Cloud revenue was $495.4 million, up 29%.
- Total Digital Media annualized recurring revenue was $4.56 billion at quarter-end, up from $3.99 billion at fiscal 2016 year-end. Creative ARR was $4.04 billion and Document Cloud ARR was $520 million.
- Cash flow from operations for the first six months was $1.375 billion, compared with $986.2 million in the prior-year period.
- Capital and other investing uses included $459.6 million for acquisitions, primarily TubeMogul, and $86.2 million for property and equipment. Financing uses included $500 million of treasury-stock purchases and $197.8 million of taxes paid on net share settlements.
- Cash and cash equivalents were $1.317 billion and short-term investments were $3.615 billion at June 2, 2017. Working capital was $3.004 billion.
- Debt had a carrying value of $1.888 billion, consisting 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 fully available.
Material changes versus the prior comparable period
- The business continued shifting toward recurring subscription revenue: subscription revenue increased to 84% of Q2 revenue from 78% a year earlier, while product revenue declined 13%.
- Cost of revenue increased 18% in Q2, mainly from higher headcount, data-center costs, hosting activity, and media costs associated with Advertising Cloud.
- Operating expenses increased 21%, primarily from higher headcount, compensation, stock-based compensation, and marketing investments. Despite these increases, operating margin expanded.
- Adobe completed and began integrating TubeMogul, acquired for a total purchase price of $560.8 million. The acquisition was integrated into Digital Marketing, and purchase accounting remained preliminary.
- Goodwill increased to $5.789 billion from $5.406 billion, principally because of TubeMogul; the annual goodwill impairment test identified no impairment.
- Adobe early adopted new share-based-payment accounting guidance. Excess tax benefits were recorded through income tax expense and operating cash flow rather than additional paid-in capital.
- The Board authorized up to $2.5 billion of share repurchases through fiscal 2019. Adobe repurchased approximately 4.3 million shares at an average price of $118 during the first six months and had $2.2 billion remaining under the current authority after a subsequent $300 million prepayment.
Guidance, outlook, commentary, risks, and unusual items
The filing does not provide clear numerical revenue or earnings guidance. Management described Q2 results as strong and emphasized continued investment in Creative Cloud, Document Cloud, Adobe Experience Cloud, research and development, sales, marketing, and international expansion. 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.
- Key operating risks include subscription renewal rates, customer adoption and pricing, extended enterprise sales cycles, competitive pressure, and execution of the transition from perpetual licenses to subscriptions.
- Cloud and hosted-service risks include outages, data-center dependency, cybersecurity incidents, privacy regulation, data-transfer restrictions, and third-party service-provider failures.
- TubeMogul integration and other acquisitions may create integration, retention, amortization, impairment, litigation, and execution risks.
- Foreign exchange movements affected reported revenue; hedging partly offset the impact. Q2 reported revenue was reduced by approximately $5.8 million after hedging, while the six-month net impact was approximately $0.4 million.
- Unrecognized tax benefits were $164.9 million, excluding interest and penalties; accrued interest and penalties were $19.5 million. Potential reductions in unrecognized tax benefits within twelve months were estimated at $0 to approximately $25 million.
- Legal proceedings and intellectual-property claims remain possible, but the filing states that no material accrual or additional disclosure was required for claims not otherwise described.
- New revenue-recognition and lease standards had not yet been adopted. Adobe expected the revenue standard to affect the timing of revenue recognition for certain term-based software arrangements and was still evaluating the full impact.
Important facts for investors to verify
- Reconcile ARR growth with recognized subscription revenue, deferred revenue, bookings, customer additions, and renewal rates.
- Assess whether increased operating expenses, data-center costs, media costs, and stock-based compensation remain consistent with future margin expansion.
- Review TubeMogul integration progress, contribution to Advertising Cloud revenue, and any changes to preliminary purchase accounting.
- Monitor the $1.888 billion debt balance, 2020 and 2025 maturities, interest costs, credit-facility covenants, and cash deployment through repurchases and acquisitions.
- Evaluate exposure to cybersecurity, privacy, service outages, foreign exchange, tax examinations, intellectual-property claims, and potential goodwill or intangible-asset impairment.
- Confirm the eventual effects of the new revenue-recognition and lease accounting standards on reported revenue, deferred revenue, assets, liabilities, and comparability.