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

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Form 10-Q for ADOBE SYSTEMS INC


28-Jun-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 second quarter of fiscal 2013, we reported strong 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.
Within our Digital Marketing segment, revenue from Adobe Marketing Cloud has increased 17% and 18% during the three and six months ended May 31, 2013, respectively, compared to the year ago periods. In addition, during the six months ended May 31, 2013, we introduced a managed services, term-based offering of Adobe Experience Manager for which revenue is recognized ratably. We expect continued adoption of this offering will increase recurring revenue in this segment which may impact the timing of Adobe Experience Manager revenue recognition.
Within our Digital Media segment, in May 2012, we launched Adobe Creative Suite
6 ("CS6") which is at the center of 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 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. While we continue to offer the perpetual licensing model as we transition our customers to the subscription-based model, we plan to focus our future creative software development efforts on the Creative Cloud subscription offering.


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During the first six months of fiscal 2013, adoption of our Creative Cloud subscription offering continued to accelerate, 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 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 recognized, 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 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 six months ended May 31, 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.
Goodwill Impairment

In accordance with updated goodwill impairment guidance issued by the Financial Accounting Standards Board ("FASB") , we completed our annual goodwill impairment test during the second quarter of fiscal 2013. We elected to use the Step 1 quantitative assessment for our three reporting units-Digital Media, Digital Marketing and Print and Publishing-and determined there was no impairment of goodwill. There is no significant risk of material goodwill impairment in any of our reporting units, based upon the results of our annual goodwill impairment test.

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


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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.
In February 2013, the FASB further amended the above accounting standards to improve the presentation of amounts reclassified out of accumulated other comprehensive income in its entirety and by component by presenting the reclassification adjustments on either the face of the the statement where net income is presented or in a separate disclosure in the notes to the financial statements. Amounts that are not required to be reclassified in their entirety to net income are required to be cross referenced to related footnote disclosures that provide additional detail. We elected to early adopt the amended accounting standard at the beginning of our second quarter of fiscal 2013 by electing to present the reclassification adjustments and other required disclosures in a separate footnote.
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.
RESULTS OF OPERATIONS
Financial Performance Summary for the Second Quarter of Fiscal 2013

We continue to derive the majority of our revenue from perpetual licenses. However, consistent with our strategy, during the three months ended May 31, 2013, our subscription revenue as a percentage of total revenue increased to 25% from 14%, compared to the year ago period, as we transition more of our business to a subscription-based model.

Total Digital Media ARR of approximately $440.0 million as of May 31, 2013 increased by $237.0 million, or 117% from November 30, 2012, primarily due to increases in the number of paid Creative Cloud individual and team subscribers and adoption of our enterprise Creative Cloud offering through our ETLAs.

Our total deferred revenue of $691.3 million as of May 31, 2013 increased by $71.7 million, or 12% from November 30, 2012, primarily due to increases in ETLAs and renewals for our Adobe Marketing Cloud services.

Cost of revenue of $135.3 million increased by $4.4 million, or 3%, year-over-year during the three months ended May 31, 2013, from $130.9 million. The increase is primarily due to increases in costs associated with compensation and related benefits driven by additional headcount and increased hosting and server costs associated with our subscription and SaaS offerings.

Operating expenses of $764.0 million increased by $75.6 million, or 11%, year-over-year during the three months ended May 31, 2013 from $688.4 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 write-down of assets reclassified as held for sale.

Net income of $76.5 million decreased by $147.4 million, or 66%, year-over-year during the three months ended May 31, 2013 from $223.9 million. The decrease is primarily due to the revenue model becoming more ratable as well as the reasons stated above.

Net cash flow from operations of $621.2 million during the six months ended May 31, 2013 decreased by $141.4 million, or 19% compared to the six months ended June 1, 2012 primarily due to lower net income as discussed above.


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Revenue for the Three and Six Months Ended May 31, 2013 and June 1, 2012
(dollars in millions)
                                  Three Months                                 Six Months
                               2013          2012         % Change         2013          2012         % Change
Product                     $   644.9     $   871.0          (26 )%     $ 1,320.7     $ 1,679.5          (21 )%
Percentage of total revenue        64 %          78 %                          65 %          78 %
Subscription                    254.5         159.5           60  %         478.8         305.8           57  %
Percentage of total revenue        25 %          14 %                          24 %          14 %
Services and support            111.1          93.9           18  %         218.9         184.4           19  %
Percentage of total revenue        11 %           8 %                          11 %           8 %
Total revenue               $ 1,010.5     $ 1,124.4          (10 )%     $ 2,018.4     $ 2,169.7           (7 )%

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 $254.5 million and $478.8 million in subscription revenue during the three and six months ended May 31, 2013 respectively, approximately $159.5 million and $314.3 million, respectively, is from our Digital Marketing segment, with the remaining amounts substantially representing our Digital Media segment offerings. Of the $159.5 million and $305.8 million in subscription revenue during the three and six months ended June 1, 2012, respectively, approximately $138.2 million and $267.4 million, respectively, is from our Digital Marketing segment, with the remaining amounts substantially 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 16 of our Notes to Condensed Consolidated Financial Statements, we have the following segments: Digital Media, Digital Marketing and Print and Publishing.

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                                 Six Months
                               2013          2012         % Change         2013          2012         % Change
Digital Media               $   670.0     $   812.6          (18 )%     $ 1,358.4     $ 1,537.0          (12 )%
Percentage of total revenue        66 %          72 %                          67 %          71 %
Digital Marketing               285.4         256.8           11  %         553.1         522.6            6  %
Percentage of total revenue        28 %          23 %                          28 %          24 %
Print and Publishing             55.1          55.0            -  %         106.9         110.1           (3 )%
Percentage of total revenue         6 %           5 %                           5 %           5 %
Total revenue               $ 1,010.5     $ 1,124.4          (10 )%     $ 2,018.4     $ 2,169.7           (7 )%

Digital Media

Revenue from Digital Media decreased $142.6 million and $178.6 million during the three and six months ended May 31, 2013, respectively, as compared to the three and six months ended June 1, 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 Creative Cloud, decreased during the three and six months ended May 31, 2013 as compared to the three and six months


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ended March 2, 2012 due to continued customer adoption of Creative Cloud subscription offerings, released in May 2012. We continue to anticipate accelerated adoption of Creative Cloud, for which revenue is recognized over time, and that this adoption has and will continue to cause our traditional perpetual license revenue to decline.

Revenue associated with our other creative products increased during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012 primarily due to increases associated with distribution of third-party software via Flash Player downloads and our Digital Publishing Suite. These increases were offset in part by decreases associated with lower than expected demand for our Photoshop Elements family of products as well as an expected decline in demand for Lightroom 4 due to the Lightroom 5 release in June 2013.

For our creative offerings, the total number of perpetual units licensed decreased while the number of subscription units licensed increased during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012. Unit average selling prices, excluding subscriptions, remained relatively stable during the three months ended May 31, 2013 and decreased during the six months ended May 31, 2013 as compared to the same periods in the prior year.

Document Services revenue, which includes our Acrobat product family, decreased during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012 primarily due to the continued shift to ETLAs offset in part by increased Document Exchange Services revenue including revenue generated from our EchoSign e-signing service.

Within Document Services, excluding large enterprise license agreement deals, the number of units decreased while the unit average selling prices increased for the three and six months ended May 31, 2013, as compared to the three and six months ended June 1, 2012.

Digital Marketing

Revenue from Digital Marketing increased $28.6 million and $30.5 million during the three and six months ended May 31, 2013, respectively, as compared to the three and six months ended June 1, 2012. The increases were primarily due to continued revenue growth associated with our Adobe Marketing Cloud, which increased 17% and 18% during the three and six months ended May 31, 2013, respectively, as compared to the year ago periods. Adobe Marketing Cloud revenue growth during the three and six months ended May 31, 2013 as compared to the year ago periods was slightly impacted due to some customer adoption of Adobe Experience Manager through a managed services, term-based offering for which revenue is recognized ratably as opposed to upfront. We expect continued adoption of this offering will increase recurring revenue in this segment which may impact the timing of Adobe Experience Manager revenue recognition. In addition, revenue associated with Adobe LiveCycle declined during the three and six months ended May 31, 2013, as expected. Print and Publishing

Revenue from Print and Publishing remained relatively stable during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012 , primarily due to decreases in royalties related to PostScript products offset by a nonrecurring font licensing transaction in the second quarter of fiscal 2013.
Geographical Information (dollars in millions)

                           Three Months                                  Six Months
                       2013           2012         % Change          2013           2012         % Change
Americas            $   525.4     $    551.3           (5 )%     $  1,025.7     $  1,054.4           (3 )%
Percentage of total
revenue                    52 %           49 %                           51 %           49 %
EMEA                    262.8          325.0          (19 )%          560.3          655.7          (15 )%
Percentage of total
revenue                    26 %           29 %                           28 %           30 %
APAC                    222.3          248.1          (10 )%          432.4          459.6           (6 )%
Percentage of total
revenue                    22 %           22 %                           21 %           21 %
Total revenue       $ 1,010.5     $  1,124.4          (10 )%     $  2,018.4     $  2,169.7           (7 )%

Overall revenue declined across all geographies during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012. Revenue in the Americas declined during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012 due to decreases in Digital Media and Print and Publishing revenue,


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offset in part by increases in Digital Marketing revenue. The weakening of the Euro and the British Pound against the U.S. Dollar caused revenue in EMEA to decline during the three and six months ended May 31, 2013 compared with the comparable periods a year earlier. During the three months ended May 31, 2013, revenue in EMEA decreased due to a decline in Digital Marketing revenue while revenues in Digital Marketing and Print and Publishing remained relatively stable when compared to three months ended June 1, 2012. Revenue in EMEA decreased across all reportable segments during the six months ended May 31, 2013 as compared to the six months ended June 1, 2012. Revenue in APAC decreased during the three and six months ended May 31, 2013 as compared to the three and six months ended June 1, 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 and six months ended May 31, 2013 as compared to the three and six months ended June 1, 2012 were impacts associated with foreign currency as shown below. (in millions) Three Months Six Months Revenue impact: Increase/(Decrease) EMEA:

Euro                 $      (1.9 )    $      (2.3 )
British Pound               (2.1 )           (2.5 )
Other currencies               -              0.1
Total EMEA                  (4.0 )           (4.7 )
Japanese Yen               (16.8 )          (28.4 )
Other currencies            (0.1 )           (0.5 )
Total revenue impact       (20.9 )          (33.6 )
Hedging impact:
Japanese Yen                13.3             20.4
EMEA                         2.0              2.0
Total hedging impact        15.3             22.4
Total impact         $      (5.6 )    $     (11.2 )

During the three and six months ended May 31, 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 and EMEA hedging programs resulted in hedging gains during the three and six months ended May 31, 2013 as noted in the table above. Cost of Revenue for the Three and Six Months Ended May 31, 2013 and June 1, 2012
(dollars in millions)

                                Three Months                          Six Months
                              2013        2012       % Change      2013        2012       % Change
Product                     $  26.8     $  40.1       (33 )%     $  78.8     $  65.8         20 %
Percentage of total revenue       3 %         4 %                      4 %         3 %
Subscription                   66.5        54.8        21  %       129.1       103.6         25 %
Percentage of total revenue       7 %         5 %                      6 %         5 %
Services and support           42.0        36.0        17  %        84.1        69.8         20 %
Percentage of total revenue       4 %         3 %                      4 %         3 %
Total cost of revenue       $ 135.3     $ 130.9         3  %     $ 292.0     $ 239.2         22 %

Product
Cost of product revenue includes product packaging, third-party royalties, . . .

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