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ADBE > SEC Filings for ADBE > Form 10-Q on 28-Mar-2013All Recent SEC Filings

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Form 10-Q for ADOBE SYSTEMS INC


28-Mar-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto.
In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements, including statements regarding product plans, future growth and market opportunities, which involve risks and uncertainties that could cause actual results to differ materially from these forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled "Risk Factors" in Part II, Item 1A of this report. You should carefully review the risks described herein and in other documents we file from time to time with the Securities and Exchange Commission (the "SEC"), including our Annual Report on Form 10-K for fiscal 2012. When used in this report, the words "expects," "could," "would," "may," "anticipates," "intends," "plans," "believes," "seeks," "targets," "estimates," "looks for," "looks to," "continues" and similar expressions, as well as statements regarding our focus for the future, are generally intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.
BUSINESS OVERVIEW Founded in 1982, Adobe Systems Incorporated is one of the largest and most diversified software companies in the world. We offer a line of software and services used by creative professionals, marketers, knowledge workers, application developers, enterprises and consumers for creating, managing, delivering, measuring, optimizing and engaging with compelling content and experiences across multiple operating systems, devices and media. We market and license our software directly to enterprise customers through our sales force and to end users through app stores and our own website at www.adobe.com. We also distribute our products through a network of distributors, value-added resellers ("VARs"), systems integrators, independent software vendors ("ISVs"), retailers and original equipment manufacturers ("OEMs"). In addition, we license our technology to hardware manufacturers, software developers and service providers for use in their products and solutions. We offer some of our products via a Software-as-a-Service ("SaaS") model (also known as a hosted or "cloud-based" model) as well as through term subscription and pay-per-use models. Our software runs on personal computers ("PCs") and server-based computers, as well as on mobile, tablets and other devices, depending on the product. We have operations in the Americas, Europe, Middle East and Africa ("EMEA") and Asia-Pacific ("APAC").
We maintain executive offices and principal facilities at 345 Park Avenue, San Jose, California 95110-2704. Our telephone number is 408-536-6000. We maintain a website at www.adobe.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC website at www.sec.gov.
OPERATIONS OVERVIEW For our first quarter of fiscal 2013, we reported solid financial results consistent with the continued execution of our plans for our two strategic growth areas, Digital Media and Digital Marketing, while continuing to market and license a broad portfolio of products and solutions.
In May 2012, we launched Adobe Creative Suite 6 ("CS6") which is at the center of Adobe Creative Cloud, our new subscription-based model for creating and publishing content and applications that was also released in May 2012. The launch of CS6 included major updates to all of our core Creative Suite ("CS") point products as well as four suite versions. Late in the fourth quarter of fiscal 2012, we launched Creative Cloud for teams, a platform for teams and workgroups to access all applications and online services in the Creative Cloud. Over time, we expect Creative Cloud to transform our business model and drive higher revenue growth through an expansion of our customer base by acquiring new users through a lower cost of entry, as well as keeping existing customers current on our latest release. This model will drive our revenue to be more recurring and predictable since revenue is recognized ratably. We continue to implement strategies that will accelerate the adoption of our Creative Cloud subscription model, causing our traditional perpetual license revenue to decline. We currently plan to continue to offer the perpetual licensing model as we transition our customers to this new subscription-based model.
Adoption of our Creative Cloud subscription offering continued to accelerate in the first quarter of fiscal 2013, which has and will continue to cause our traditional perpetual license revenue and, in turn, total net revenue in fiscal 2013, to decline. As anticipated during this transition, expenses did not and are not expected to decline in correlation to the decrease in revenue, which will adversely affect our net income and operating margin throughout fiscal 2013. However, over time we expect this business model transition will significantly increase our long-term revenue growth rate by attracting new users, keeping our end user base


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current and thereby driving higher average revenue per user. Additionally, our shift to a subscription model will increase the amount of recurring revenue that is ratably reported, driven by broader Creative Cloud adoption over the next several years.

To assist with the understanding of this transition and the related shift in revenue described above, we are using certain performance metrics to assess the health and trajectory of our overall Digital Media segment.

These metrics include the total number of current paid subscriptions and Annualized Recurring Revenue ("ARR"). We define ARR as the sum of:

the number of current paid subscriptions, multiplied by the average subscription price paid per user per month, multiplied by twelve months; plus,

twelve months of contract value of Enterprise Term License Agreements ("ETLAs") where the revenue is ratably recognized over the life of the contract.

In addition, we expect renewal rates associated with Creative Cloud, and potentially other subscription offerings, will become key metrics used to measure their performance. Because the majority of Creative Cloud subscriptions have been annual and the Creative Cloud launched in May 2012, we have not yet reached the first anniversary of these annual subscriptions and, therefore, we anticipate that meaningful data regarding subscription renewal rates will first become available later in fiscal year 2013.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our Condensed Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America ("GAAP") and pursuant to the rules and regulations of the SEC, we make assumptions, judgments and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates. We also discuss our critical accounting policies and estimates with the Audit Committee of the Board of Directors. We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, stock-based compensation, business combinations, goodwill impairment and income taxes have the greatest potential impact on our Condensed Consolidated Financial Statements. These areas are key components of our results of operations and are based on complex rules requiring us to make judgments and estimates, so we consider these to be our critical accounting policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.
With the exception of the discussion below, there have been no significant changes in our critical accounting policies and estimates during the three months ended March 1, 2013, as compared to the critical accounting policies and estimates disclosed in Management's Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended November 30, 2012.
Recent Accounting Pronouncements

In December 2011, the FASB amended the accounting standards to increase the prominence of other comprehensive income ("OCI") by eliminating the option to present components of OCI as part of the statement of changes in shareholders' equity and requires the components of OCI to be presented either in a single continuous statement of comprehensive income or in two consecutive statements. We adopted the amended accounting standards at the beginning of our first quarter of fiscal 2013 by electing to present separate consolidated statements of comprehensive income from the consolidated statements of income. The amended accounting standards only impact the financial statement presentation of OCI and do not change the components that are recognized in net income or OCI. The adoption had no impact on the Company's financial position or results of operations.
Recent Accounting Pronouncements Not Yet Effective There have been no new accounting pronouncements not yet effective that have significance, or potential significance, to our condensed consolidated financial statements.


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RESULTS OF OPERATIONS

Financial Performance Summary for the First Quarter of Fiscal 2013

We continue to derive the majority of our revenue from perpetual licenses. However, during the three months ended March 1, 2013, our subscription revenue as a percentage of total revenue increased to 22% from 14% in the year ago period, as we transition more of our business to a subscription-based model.

Total Digital Media ARR of $297.0 million as of March 1, 2013 increased by $94.0 million, or 46% from November 30, 2012, primarily due to increases in the number of paid Creative Cloud individual and team subscribers.

Our total deferred revenue of $700.0 million as of March 1, 2013 increased by $80.5 million, or 13% in the first quarter of fiscal 2013 primarily due to increases in enterprise term licenses agreements and renewals for our Adobe Marketing Cloud services.

Cost of revenue and operating expenses of $909.6 million increased by $153.4 million, or 20%, year-over-year during the three months ended March 1, 2013 from $756.2 million. The increase is primarily due to increases in costs associated with compensation and related benefits driven by additional headcount and to a lesser extent, a one-time charge associated with technology licensing arrangements.

Net income of $65.1 million decreased by $120.1 million, or 65%, year-over-year during the three months ended March 1, 2013 from $185.2 million primarily due to the reasons stated above and offset in part by the effects of the extension of the federal research and development credit.

Net cash flow from operations of $322.0 million during the three months ended March 1, 2013 remained relatively stable compared to the three months ended March 2, 2012.

Revenue for the Three Months Ended March 1, 2013 and March 2, 2012 (dollars in

millions)
                                  Three Months
                               2013          2012        % Change
Product                     $   675.8     $   808.5       (16 )%
Percentage of total revenue        67 %          77 %
Subscription                    224.3         146.2        53  %
Percentage of total revenue        22 %          14 %
Services and support            107.8          90.5        19  %
Percentage of total revenue        11 %           9 %
Total revenue               $ 1,007.9     $ 1,045.2        (4 )%

Our subscription revenue is comprised primarily of fees we charge for our subscription and hosted service offerings including certain of our Adobe Marketing Cloud services and Creative Cloud. We recognize subscription revenue ratably over the term of agreements with our customers, beginning on the commencement of the service. We expect our subscription revenue will continue to increase as a result of our investments in new SaaS and subscription models. We also expect this to increase the amount of recurring revenue we generate as a percent of our total revenue. Of the $224.3 million and $146.2 million in subscription revenue during the three months ended March 1, 2013 and March 2, 2012, respectively, approximately $154.9 million and $129.1 million, respectively, is from our Digital Marketing segment, with the remaining amounts representing our Digital Media segment offerings.

Our services and support revenue is comprised of consulting, training and maintenance and support, primarily related to the licensing of our enterprise, developer and platform products and the sale of our hosted Adobe Marketing Cloud services. Our support revenue also includes technical support and developer support to partners and developer organizations related to our desktop products. Our maintenance and support offerings, which entitle customers to receive desktop product upgrades and enhancements or technical support, depending on the offering, are generally recognized ratably over the term of the arrangement.

As described in Note 15 of our Notes to Condensed Consolidated Financial Statements, we have the following segments: Digital Media, Digital Marketing and Print and Publishing.


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Effective in the first quarter of fiscal 2013, we moved our video server solutions products from our Digital Media segment to our Digital Marketing segment to better align the role of how Adobe can help its customers monetize their video assets with our Digital Marketing solutions. Prior year information has been updated to reflect this change.

Segment Information (dollars in millions)

                                  Three Months
                               2013          2012       % Change
Digital Media               $   688.4     $   724.4       (5 )%
Percentage of total revenue        68 %          70 %
Digital Marketing               267.7         265.8        1  %
Percentage of total revenue        27 %          25 %
Print and Publishing             51.8          55.0       (6 )%
Percentage of total revenue         5 %           5 %
Total revenue               $ 1,007.9     $ 1,045.2       (4 )%

Digital Media

Revenue from Digital Media decreased $36.0 million during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012, primarily due to continued strong adoption of Creative Cloud and ETLAs as we continue to transition more of our business to a subscription-based model.

Revenue related to our creative professional products, which include our Creative Suite editions and CS point products as well as the recently released Creative Cloud, decreased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 due to continued customer adoption of Creative Cloud subscription offerings, released in May 2012. We anticipate accelerated adoption of Creative Cloud, for which revenue is recognized over time, and that this adoption will cause our traditional perpetual license revenue to decline.

Revenue associated with our other creative products increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 primarily due to increases associated with distribution of third-party software via Flash Player downloads and our Digital Publishing Suite, as well as continued demand related to the May 2012 release of Adobe Lightroom 4. These increases were offset in part by decreases associated with lower than expected demand for our Photoshop Elements family of products.

For our creative offerings, the total number of perpetual units licensed decreased while the number of subscription units licensed increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012. Unit average selling prices, excluding subscriptions, remained relatively stable during the three months ended March 1, 2013 as compared to the same period in the prior year.

Document Services revenue, which includes our Acrobat product family, also increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 primarily due to increased Document Exchange Services revenue including revenue generated from our EchoSign eSignatures service offset in part by the shift to ETLAs.

Within Document Services, excluding large enterprise license agreement deals, the number of units decreased while the unit average selling prices increased for the three months ended March 1, 2013, as compared to the three months ended March 2, 2012.

Digital Marketing

Revenue from Digital Marketing increased slightly during the three months ended March 1, 2013, as compared to the three months ended March 2, 2012 due to continued revenue growth associated with our Adobe Marketing Cloud, which increased 20% year-over-year. As expected, increases were offset by a decrease in revenue associated with Adobe LiveCycle product offerings as we continue to maintain our focus on Adobe Marketing Cloud.


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Print and Publishing

Revenue from Print and Publishing decreased $3.2 million during the three ended
March 1, 2013 as compared to the three months ended March 2, 2012, primarily due
to decreases in fees received for consulting services and royalties related to
PostScript products.
Geographical Information (dollars in millions)
                                  Three Months
                               2013          2012        % Change
Americas                    $   500.3     $   503.1        (1 )%
Percentage of total revenue        50 %          48 %
EMEA                            297.5         330.7       (10 )%
Percentage of total revenue        30 %          32 %
APAC                            210.1         211.4        (1 )%
Percentage of total revenue        20 %          20 %
Total revenue               $ 1,007.9     $ 1,045.2        (4 )%

Overall revenue during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 remained relatively stable in the Americas and APAC and declined in EMEA. Revenue in the Americas remained relatively stable during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 due to increases in Digital Marketing revenue, offset in part by declines in Digital Media and Print and Publishing revenue. The economic conditions in Europe and the weakening of the Euro and the British Pound against the U.S. Dollar caused revenue in EMEA to decline during the three months ended March 1, 2013 compared with the comparable period a year earlier. Revenue in EMEA decreased across all reportable segments during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012. Revenue in APAC remained relatively stable during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 due to declines in Digital Media, offset by increases in Digital Marketing and Print and Publishing. Within each geographical region, the fluctuations in revenue by reportable segment were attributable to the factors noted in the segment information above. Included in the overall decrease in revenue for the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 were impacts associated with foreign currency as shown below.

(in millions)                  2013
Revenue impact:         Increase/(Decrease)
EMEA:
Euro                 $              (0.4 )
British Pound                       (0.4 )
Other currencies                     0.1
Total EMEA                          (0.7 )
Japanese Yen                       (11.6 )
Other currencies                    (0.4 )
Total revenue impact               (12.7 )
Hedging impact:
Japanese Yen                         7.1
Total hedging impact                 7.1
Total impact         $              (5.6 )

During the three months ended March 1, 2013, the U.S. Dollar strengthened against all major currencies causing revenue in EMEA and Japan measured in U.S. Dollar equivalents to decrease compared with the same reporting period last year. Our Yen currency hedging programs resulted in hedging gains during the three months ended March 1, 2013 as noted in the table above.


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Cost of Revenue for the Three Months Ended March 1, 2013 and March 2, 2012
(dollars in millions)
                                Three Months
                              2013        2012      % Change
Product                     $  52.0     $  25.7        102 %
Percentage of total revenue       5 %         2 %
Subscription                   62.6        48.8         28 %
Percentage of total revenue       6 %         5 %
Services and support           42.1        33.8         25 %
Percentage of total revenue       4 %         3 %
Total cost of revenue       $ 156.7     $ 108.3         45 %

Product
Cost of product revenue includes product packaging, third-party royalties, excess and obsolete inventory, amortization related to localization costs, purchased intangibles and acquired rights to use technology and the costs associated with the manufacturing of our products.
Cost of product revenue increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 due to the following:

% Change
2013-2012
                                                                                  QTD
Amortization of purchased intangibles and technology license arrangements          106  %
Cost of sales                                                                      (11 )
Royalty cost                                                                         9
Localization costs related to our product launches                                   5
Excess and obsolete inventory                                                       (4 )
Various individually insignificant items                                            (3 )
Total change                                                                       102  %


Amortization of purchase intangibles and technology license arrangements
increased during the three months ended March 1, 2013 as compared to the three
months ended March 2, 2012 as we entered into certain technology licensing
arrangements totaling $51.8 million during the three months ended March 1, 2013.
Of this cost, an estimated $25.3 million was related to future licensing rights
and has been capitalized and will be amortized on a straight-line basis over the
estimated useful lives ranging from five to ten years. We estimated that the
remaining cost of approximately $26.5 million was related to historical use of
licensing rights and was expensed as cost of product revenue. In connection with
certain of these licensing arrangements, we have the ability to acquire
additional rights to use technology in the future.
Cost of sales decreased during the three months ended March 1, 2013 as compared
to the three months ended March 2, 2012 primarily due to decreases in the number
of perpetual units sold and packaging costs associated with our CS6 products.
Royalty costs increased during the three months ended March 1, 2013 as compared
to the three months ended March 2, 2012 primarily due to increases in
obligations to certain key vendors and royalty costs associated with the launch
of CS6 and Creative Cloud in the second quarter of fiscal 2012.
Localization costs increased during the three months ended March 1, 2013 as
compared to the three months ended March 2, 2012 primarily due to released
updates for CS6 during the quarter and the product launch of Acrobat XI in the
fourth quarter of fiscal 2012.

Excess and obsolete inventory decreased during the three months ended March 1,
2013 as compared to the three months ended March 2, 2012 due to decreased
reserve requirements for CS6.


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Subscription
Cost of subscription revenue consists of expenses related to operating our network infrastructure, including depreciation expenses and operating lease payments associated with computer equipment, data center costs, salaries and related expenses of network operations, implementation, account management and technical support personnel, amortization of intangible assets and allocated overhead. We enter into contracts with third parties for the use of their data center facilities and our data center costs largely consist of the amounts we pay to these third parties for rack space, power and similar items. Cost of subscription revenue increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 due to the following:

% Change
2013-2012
                                         QTD
Hosted server costs                       19 %
Amortization of purchased intangibles      9 %
Total change                              28 %

Hosted server costs increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 primarily due to increases in compensation and related benefits driven by additional headcount from our acquisitions of Efficient Frontier in the later part of the first quarter of fiscal 2012 and Behance in the first quarter of fiscal 2013, depreciation expense from higher capital expenditures after the first quarter of fiscal 2012 and data center costs related to higher transaction volumes in our Adobe Marketing Cloud and Creative Cloud services.
Amortization of purchase intangibles increased during the three months ended March 1, 2013 as compared to the three months ended March 2, 2012 primarily due to increased amortization of intangible assets from our acquisitions of Efficient Frontier in the later part of the first quarter of fiscal 2012 and Behance in the first quarter of fiscal 2013.

Services and Support
Cost of services and support revenue is primarily comprised of employee-related
costs and associated costs incurred to provide consulting services, training and
product support.
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