Adobe Inc. Form 10-Q Summary
Business context and reporting period
Adobe is a global software company offering Creative Cloud, Document Cloud, Adobe Experience Cloud, publishing products and related services. This unaudited Form 10-Q covers the three months ended March 1, 2019, compared with the three months ended March 2, 2018. Fiscal 2019 results reflect adoption of ASC 606 using the modified retrospective method; prior-period amounts were not restated, limiting comparability.
Key financial metrics
| Metric | Q1 FY2019 | Q1 FY2018 | Change |
|---|---|---|---|
| Total revenue | $2.601 billion | $2.079 billion | +25% |
| Subscription revenue | $2.305 billion | $1.793 billion | +29% |
| Gross profit | $2.204 billion | $1.820 billion | +21% |
| Gross margin | 84.7% | 87.5% | Down 2.8 points |
| Operating income | $694.8 million | $702.7 million | -1% |
| Operating margin | 26.7% | 33.8% | Down 7.1 points |
| Net income | $674.2 million | $583.1 million | +16% |
| Diluted EPS | $1.36 | $1.17 | +16% |
| Cash flow from operations | $1.013 billion | $989.6 million | +2% |
Net margin was approximately 25.9%, compared with 28.0% in the prior-year quarter. Revenue mix continued to shift toward subscriptions, which represented approximately 88% of total revenue versus 86% previously.
- Segment revenue: Digital Media was $1.777 billion, up 22%; Digital Experience was $743.3 million, up 34%; and Publishing was $81.0 million, up 26%.
- Digital Media: Creative Cloud revenue was $1.495 billion, up 22%, and Document Cloud revenue was $281.8 million, up approximately 22%.
- Digital Experience: Subscription revenue increased 42% to $611.9 million, driven substantially by Marketo and Magento, acquired in fiscal 2018.
- Recurring metrics: Digital Media ARR was $7.07 billion at quarter-end, including Creative ARR of $6.21 billion and Document Cloud ARR of $856 million.
- Margins and expenses: Cost of revenue rose 53% to $397.3 million, while operating expenses increased 35% to $1.509 billion. Increases reflected hosting and data-center costs, acquired intangible amortization, headcount growth, compensation and stock-based compensation.
- Liquidity: Cash and cash equivalents were $1.739 billion and short-term investments were $1.487 billion. Total cash, cash equivalents and short-term investments were approximately $3.226 billion.
- Debt: Current debt was $892.8 million and long-term debt was $3.237 billion. Debt included a $2.25 billion term loan due April 30, 2020 and approximately $1.9 billion of senior notes, including $900 million of notes due February 2020 and $1 billion due February 2025.
- Share repurchases: Adobe repurchased approximately 2.1 million shares for $500 million during the quarter. Approximately $7.51 billion remained under the repurchase authorization at March 1, 2019; a subsequent $750 million structured repurchase agreement reduced remaining authority to $6.60 billion.
Material changes versus the prior comparable period
- Revenue growth was led by subscription adoption in Creative Cloud, Document Cloud and Experience Cloud, with Marketo and Magento contributing to Digital Experience growth.
- Operating income was essentially flat despite strong revenue growth because cost of revenue and operating expenses grew faster than revenue. Acquired intangible amortization increased materially following the Marketo and Magento acquisitions.
- Net income benefited from a substantially lower income tax provision of $28.1 million versus $119.4 million, reducing the effective tax rate to approximately 4% from 17%. The prior-year rate reflected provisional accounting for the Tax Cuts and Jobs Act.
- Interest expense increased to $40.6 million from $19.9 million, primarily because of the Marketo-related term loan.
- Net investment gains increased to $43.8 million from $3.0 million, primarily due to a $41.5 million gain from remeasuring Adobe’s pre-existing Allegorithmic equity interest upon acquiring the remaining interest.
- Working capital changed from a $555.9 million surplus at November 30, 2018 to a $180.0 million deficit, primarily because the $898.7 million carrying value of the 2020 Notes was reclassified as current debt.
- Adobe adopted ASC 606, recording a $442.3 million increase to opening retained earnings and capitalizing $413.2 million of contract acquisition costs. Reported Q1 FY2019 revenue was $21.4 million higher and net income was $29.1 million higher than estimated amounts without the adoption impact.
Outlook, management commentary, risks and unusual items
Management described the quarter as strong and stated that Creative Cloud, Document Cloud, Marketo, Magento and continued demand for Experience Cloud solutions are expected to support long-term growth. Adobe stated that existing cash, investments, operating cash flows and its available credit facility should be sufficient for working-capital and operating requirements for the next twelve months. No specific full-year revenue or earnings guidance is provided in the filing text.
- Adobe expects to refinance the current portion of the 2020 Notes on or before maturity and reported compliance with its debt covenants. The $1 billion revolving credit facility was undrawn at quarter-end.
- ASC 606 changed revenue classification and timing for certain arrangements, and the filing cautions that non-restated prior-period results are not fully comparable.
- Remaining performance obligations were approximately $8.13 billion, including $602.3 million of non-cancellable committed funds; approximately 73% of the applicable balance was expected to be recognized over the following 12 months.
- Key risks include competition and pricing pressure, customer renewal and subscription attrition, cybersecurity and data privacy incidents, service outages and dependence on third-party hosting providers, foreign-exchange movements, complex enterprise sales cycles, acquisition integration, tax-law changes, intellectual-property litigation and leverage/refinancing requirements.
- Adobe disclosed potential exposure from intellectual-property indemnifications and litigation but stated that no material additional loss was probable and estimable based on the information available.
- Adobe expects to adopt the new leases standard in fiscal 2020 and expects the principal effect to be recognition of right-of-use assets and lease liabilities.
Important facts for investors to verify
- Reconcile ASC 606-adjusted Q1 FY2019 results with the prior period and assess the effect on revenue mix, deferred revenue, contract assets and retained earnings.
- Monitor Digital Media ARR growth, subscription additions, renewal rates and the sustainability of Creative Cloud and Document Cloud momentum.
- Assess whether Marketo and Magento integration produces the expected Digital Experience growth without further disproportionate increases in hosting, amortization and operating costs.
- Review the planned refinancing of the $898.7 million current debt balance and the company’s leverage covenant headroom.
- Evaluate the effect of stock repurchases and stock-based compensation on diluted share count, cash balances and shareholder returns.
- Track the unusually low 4% effective tax rate, unrecognized tax benefits of $194.4 million and the approximately $0.5 billion transition-tax liability payable through fiscal 2026.