Adobe Systems Incorporated: Fiscal 2013 First-Quarter 10-Q Summary
Business context and reporting period
Adobe is a global software and services company serving creative professionals, marketers, enterprises, developers and consumers through Digital Media, Digital Marketing, and Print and Publishing offerings. The unaudited quarter ended March 1, 2013, is compared with the quarter ended March 2, 2012. Adobe continued shifting from perpetual software licenses toward subscription and cloud-based offerings, particularly Creative Cloud and Adobe Marketing Cloud.
Financial performance and key metrics
| Metric | Q1 FY2013 | Q1 FY2012 | Change |
|---|---|---|---|
| Total revenue | $1,007.9 million | $1,045.2 million | (4%) |
| Product revenue | $675.8 million | $808.5 million | (16%) |
| Subscription revenue | $224.3 million | $146.2 million | 53% |
| Services and support revenue | $107.8 million | $90.5 million | 19% |
| Gross profit | $851.2 million | $937.0 million | (9%) |
| Gross margin | 84.5% | 89.6% | Down 5.1 points |
| Operating income | $98.2 million | $289.0 million | (66%) |
| Operating margin | 9.7% | 27.6% | Down 17.9 points |
| Net income | $65.1 million | $185.2 million | (65%) |
| Diluted earnings per share | $0.13 | $0.37 | (65%) |
| Cash flow from operations | $322.0 million | $314.4 million | 2% |
Subscription revenue represented 22% of total revenue, compared with 14% in the prior-year quarter. Digital Media revenue was $688.4 million, down 5%; Digital Marketing revenue was $267.7 million, up 1%; and Print and Publishing revenue was $51.8 million, down 6%. Adobe Marketing Cloud revenue increased 20% year over year.
Digital Media annualized recurring revenue was $297.0 million at March 1, 2013, up $94.0 million, or 46%, from November 30, 2012. Total deferred revenue was approximately $700.0 million, up $80.5 million, or 13%, during the quarter.
Cash and cash equivalents were $1.306 billion, and short-term investments were $2.354 billion, for total cash, cash equivalents and short-term investments of approximately $3.661 billion. Working capital was $3.109 billion. Net cash used in investing activities was $446.1 million, including $96.4 million for the Behance acquisition, $60.2 million for property and equipment, and purchases of short-term investments. Financing activities provided $11.4 million, including stock issuances and sale-leaseback proceeds, partly offset by $100.0 million of treasury-stock purchases.
Senior notes had principal outstanding of $1.5 billion, consisting of $600 million of 3.25% notes due 2015 and $900 million of 4.75% notes due 2020. The $1.0 billion revolving credit facility had no outstanding borrowings and was extended by one year to March 2, 2018. Capital lease obligations totaled $35.9 million. Adobe reported compliance with its debt and lease covenants.
Material changes versus the prior comparable period
- Product revenue declined as customers adopted Creative Cloud and enterprise term license arrangements, while subscription revenue increased substantially.
- Gross margin declined because of the greater mix of subscription revenue, higher hosting and infrastructure costs, increased amortization, and a one-time $26.5 million charge for historical use of licensed technology.
- Operating expenses increased 16% to $753.0 million, led by higher compensation, headcount, sales and marketing investment, research and development, and general and administrative costs.
- Cost of revenue increased 45% to $156.7 million, including a significant increase in product-related costs.
- Operating income and net income fell sharply because revenue declined while expenses and transition-related costs increased.
- Adobe completed its acquisition of Behance for an adjusted preliminary purchase price of approximately $111.1 million, primarily allocated to goodwill and identifiable intangible assets. The acquisition was not material to consolidated results.
- Goodwill increased to $4.221 billion from $4.133 billion, primarily due to Behance.
- Adobe repurchased approximately 2.7 million shares for $100.0 million of prepayments under its $2.0 billion repurchase authorization; approximately $1.833 billion remained available at quarter-end.
Guidance, outlook, management commentary, risks and unusual items
Management did not provide specific numerical quarterly or full-year guidance in the filing. Management expects Creative Cloud adoption to continue accelerating, causing perpetual-license revenue and total reported revenue to decline during the transition. Expenses are not expected to decline proportionately, which is expected to pressure fiscal 2013 net income and operating margin. Over time, management expects subscriptions to produce more recurring and predictable revenue, attract new users and increase average revenue per user.
Management expects renewal rates to become an important performance measure, but meaningful renewal data was not yet available because most annual Creative Cloud subscriptions had not reached their first anniversary. Adobe stated that existing cash, investments, operating cash flow and available credit are expected to fund working capital and operating requirements for at least the next twelve months.
Notable unusual items included the $26.5 million historical-use technology licensing charge, a $12.9 million retroactive federal research and development tax credit benefit, the Behance acquisition, and continued restructuring obligations. Restructuring liabilities totaled approximately $16.8 million, with facility-related payments extending through fiscal 2021.
Principal risks include execution of the transition to subscription and cloud models, uncertain subscription renewals and revenue timing, competition and pricing pressure, cybersecurity and service interruptions, privacy and regulatory requirements, foreign-currency exposure, intellectual-property litigation, acquisition integration, dependence on distributors and third-party service providers, tax examinations, potential goodwill impairment, and obligations under debt, lease and indemnification arrangements. Adobe also disclosed that Ingram Micro represented 8% of first-quarter net revenue.
Most important facts for investors to verify
- Whether Creative Cloud subscriber growth, annualized recurring revenue and renewal rates offset continued declines in perpetual-license revenue.
- Whether subscription mix and cloud infrastructure costs allow gross margin and operating margin to recover over time.
- Cash conversion and deferred-revenue growth relative to reported earnings during the business-model transition.
- Integration and performance of Behance and other acquired businesses, including related goodwill and intangible-asset balances.
- Remaining share-repurchase authorization, dilution from equity compensation, and the effect of repurchases on share count.
- Debt maturities, interest obligations, credit-facility availability and continued covenant compliance.
- Potential effects of tax examinations, unrecognized tax benefits, foreign earnings repatriation and changes in tax credits.
- Exposure to cybersecurity, privacy, intellectual-property, currency, litigation, restructuring and service-continuity risks.