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ADBE > SEC Filings for ADBE > Form 10-Q on 3-Oct-2013All Recent SEC Filings

Show all filings for ADOBE SYSTEMS INC

Form 10-Q for ADOBE SYSTEMS INC


3-Oct-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 third quarter of fiscal 2013, we reported strong financial results consistent with the continued execution of our plans for our two strategic growth areas, Digital Marketing and Digital Media, while continuing to market and license a broad portfolio of products and solutions.
Within our Digital Marketing segment, we are a market leader in the fast-growing category of digital marketing. Our Adobe Marketing Cloud offering includes six solutions addressing the expanding needs of marketers, the newest of which is Adobe Campaign which is a cross-channel campaign management tool that we added to our portfolio with the acquisition of Neolane during our third quarter of fiscal 2013.

Revenue from Adobe Marketing Cloud has increased 28% and 22% during the three and nine months ended August 30, 2013, respectively, compared to the year ago periods. Helping to drive this performance was strong adoption of our Adobe Experience Manager ("AEM") offering, and, the addition of Neolane mid-third quarter of fiscal 2013.

AEM, our fastest growing digital marketing solution, has typically been licensed by our customers as an on-premise offering where license revenue is recognized at the time of the transaction. In the past year, we introduced a managed services offering of AEM for which revenue is recognized ratably. We expect continued adoption of the newer managed services offering, which will increasingly migrate AEM revenue to recurring revenue in this segment. Given the comparisons involving more new license revenue being recognized over time versus past license revenue being recognized up front, we anticipate this trend may impact AEM growth rates and thus Adobe Marketing Cloud growth rates in the future.


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Within our Digital Media segment, in May 2012, we delivered Adobe Creative Cloud, our new subscription-based offering for creating and publishing content and applications. Creative Cloud is our next-generation offering that supersedes our historical model of licensing our creative products with perpetual licenses. We continue to implement strategies that will accelerate awareness, consideration and purchase of subscriptions to the offering. Key aspects of the value Creative Cloud provides include more frequent product updates, storage and access to user files stored in the cloud with syncing of files across users' machines, community-based features and services through our acquisition of Behance in December 2012, digital publishing and app creation capabilities, and lower entry point pricing for cost-sensitive customers.

In May 2013 we announced we would exclusively deliver new creative product innovations and features to Creative Cloud subscribers, and that Adobe Creative Suite 6 ("CS6") which was released in May 2012 would be the last major update we provide for perpetual licensees. While we continue to offer CS6 on a perpetual licensing basis moving forward, we expect revenue for it to sequentially decline as our customers increasingly migrate to Creative Cloud.

We offer Creative Cloud for individuals and for teams, and we enable larger enterprise customers to acquire Creative Cloud capabilities through Enterprise Term License Agreements ("ETLAs"). The three Creative Cloud offerings address the multiple routes to market we use to license our creative software to targeted customers. Adoption of Creative Cloud is transforming our business model and we expect this to 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 have implemented, and will continue to implement, strategies that accelerate adoption of our Creative Cloud subscription model, causing our traditional perpetual license revenue to decline. These strategies include increasing the value Creative Cloud users receive, as well as targeted promotions and offers that attract past customers and potential users to try out and ultimately subscribe to Creative Cloud.

During the first nine 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 compared with the same period in fiscal 2012. 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 revenue. 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 ETLAs where the revenue is ratably recognized over the life of the contract.

During the third quarter of fiscal 2013, we exceeded one million paid Creative Cloud subscriptions, exiting the quarter with one million thirty one thousand subscriptions. Total Creative ARR exiting the third quarter of fiscal 2013 was $655.0 million, up from $440.0 million exiting the second quarter of fiscal 2013, demonstrating the progress we have made with our transformation in this business.
In September 2013, Adobe's security team discovered sophisticated attacks on our network involving the illegal access to certain customer and product information. We continue to investigate this incident and are taking certain steps to help minimize any impact on our business. At this time, we do not believe that the attacks will have a material adverse impact on our business or financial results. It is possible, nevertheless, that this incident could have various adverse effects on us as described in our risk factors for these types of incidents found in Item 1A "Risk Factors" in Part II of this Quarterly Report on Form 10-Q. For additional information related to this incident, please see Item 5 "Other Information" in Part II of this Report.

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


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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 nine months ended August 30, 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 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 consolidated statements of comprehensive income separate 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 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 Third 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 August 30, 2013, our subscription revenue as a percentage of total revenue increased to 30% compared with 16%, in the year ago period, as we transition more of our business to a subscription-based model.

Total Digital Media ARR of approximately $203.0 million as of November 30, 2012 has increased each quarter to approximately $297.0 million as of March 1, 2013, to $440.0 million as of May 31, 2013, and to $655.0 million as of August 30, 2013. The increase in our Digital Media ARR from November 30, 2012 to August 30, 2013 of approximately


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$452.0 million, or 223%, is primarily due to increases in the number of paid Creative Cloud individual and team subscriptions and adoption of our enterprise Creative Cloud offering through our ETLAs.

Our total deferred revenue of $734.1 million as of August 30, 2013 increased by $114.5 million, or 18% from November 30, 2012, primarily due to increases in subscriptions, ETLAs and renewals for our Adobe Marketing Cloud services.

Cost of revenue of $147.1 million increased by $27.5 million, or 23%, year-over-year during the three months ended August 30, 2013, from $119.6 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 $737.7 million increased by $55.0 million, or 8%, year-over-year during the three months ended August 30, 2013 from $682.7 million. The increase is primarily due to increases in costs associated with compensation and related benefits driven by additional headcount.

Net income of $83.0 million decreased by $118.4 million, or 59%, year-over-year during the three months ended August 30, 2013 from $201.4 million. The decrease is primarily due to our revenue model becoming more ratable as well as the reasons stated above.

Net cash flow from operations of $836.7 million during the nine months ended August 30, 2013 decreased by $189.2 million, or 18% compared to the nine months ended August 31, 2012 primarily due to lower net income as discussed above.

Revenue for the Three and Nine Months Ended August 30, 2013 and August 31, 2012
(dollars in millions)
                                  Three Months                                 Nine Months
                               2013          2012         % Change         2013          2012         % Change
Product                     $   582.2     $   810.5          (28 )%     $ 1,902.9     $ 2,490.0          (24 )%
Percentage of total revenue        59 %          75 %                          63 %          77 %
Subscription                    299.3         172.9           73  %         778.1         478.7           63  %
Percentage of total revenue        30 %          16 %                          26 %          15 %
Services and support            113.6          97.2           17  %         332.5         281.5           18  %
Percentage of total revenue        11 %           9 %                          11 %           8 %
Total revenue               $   995.1     $ 1,080.6           (8 )%     $ 3,013.5     $ 3,250.2           (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 $299.3 million and $778.1 million in subscription revenue during the three and nine months ended August 30, 2013, respectively, approximately $169.0 million and $483.4 million, respectively, is from our Digital Marketing segment, with the remaining amounts substantially representing our Digital Media segment offerings. Of the $172.9 million and $478.7 million in subscription revenue during the three and nine months ended August 31, 2012, respectively, approximately $141.5 million and $408.9 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.


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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                                 Nine Months
                               2013          2012         % Change         2013          2012         % Change
Digital Media               $   636.7     $   762.5          (16 )%     $ 1,995.1     $ 2,299.5          (13 )%
Percentage of total revenue        64 %          71 %                          66 %          71 %
Digital Marketing               311.7         263.7           18  %         864.8         786.2           10  %
Percentage of total revenue        31 %          24 %                          29 %          24 %
Print and Publishing             46.7          54.4          (14 )%         153.6         164.5           (7 )%
Percentage of total revenue         5 %           5 %                           5 %           5 %
Total revenue               $   995.1     $ 1,080.6           (8 )%     $ 3,013.5     $ 3,250.2           (7 )%

Digital Media

Revenue from Digital Media decreased $125.8 million and $304.4 million during the three and nine months ended August 30, 2013, respectively, as compared to the three and nine months ended August 31, 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 nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 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 individuals, teams and enterprises, 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 nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 2012 primarily due to increases associated with distribution of third-party software via Flash Player downloads and our Digital Publishing Suite.

For our creative offerings, the total number of perpetual units licensed decreased while the number of subscription units licensed increased during the three and nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 2012. Unit average selling prices, excluding subscriptions, decreased during the three and nine months ended August 30, 2013 as compared to the same periods in the prior year.

Document Services revenue, which includes our Acrobat product family, decreased slightly during the three and nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 2012 primarily due to the continued shift to ETLAs offset 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 licensed decreased while the unit average selling prices remained relatively stable for the three months ended August 30, 2013, as compared to the three months ended August 31, 2012. For the nine months ended August 31, 2013, the number of units licensed decreased while the unit average selling prices increased compared to the year ago period.

Digital Marketing

Revenue from Digital Marketing increased $48.0 million and $78.6 million during the three and nine months ended August 30, 2013, respectively, as compared to the three and nine months ended August 31, 2012. The increases were primarily due to continued revenue growth associated with our Adobe Marketing Cloud, which increased 28% and 22% during the three and nine months ended August 30, 2013, respectively, as compared to the year ago periods. The increase noted above was offset by a decline in revenue associated with Adobe LiveCycle during the three and nine months ended August 30, 2013, as expected.


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Print and Publishing

Revenue from Print and Publishing decreased during the three and nine months
ended August 30, 2013 as compared to the three and nine months ended August 31,
2012, primarily due to increased ETLAs for some products in this group.
Geographical Information (dollars in millions)
                           Three Months                                  Nine Months
                       2013           2012         % Change          2013           2012         % Change
Americas            $   534.0     $    558.3           (4 )%     $  1,559.7     $  1,612.7           (3 )%
Percentage of total
revenue                    54 %           52 %                           52 %           50 %
EMEA                    263.9          290.0           (9 )%          824.1          945.6          (13 )%
Percentage of total
revenue                    26 %           27 %                           27 %           29 %
APAC                    197.2          232.3          (15 )%          629.7          691.9           (9 )%
Percentage of total
revenue                    20 %           21 %                           21 %           21 %
Total revenue       $   995.1     $  1,080.6           (8 )%     $  3,013.5     $  3,250.2           (7 )%

Revenue declined across all geographies during the three and nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 2012 due to decreases in Digital Media and Print and Publishing revenue, offset in part by increases in Digital Marketing revenue. 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 nine months ended August 30, 2013 as compared to the three and nine months ended August 31, 2012 were impacts associated with foreign currency as shown below. (in millions) Three Months Nine Months Revenue impact: Increase/(Decrease) EMEA:

Euro                 $       5.5      $       3.2
British Pound               (1.0 )           (3.5 )
Other currencies             0.2              0.3
Total EMEA                   4.7                -
Japanese Yen               (20.5 )          (48.9 )
Other currencies            (2.2 )           (2.7 )
Total revenue impact       (18.0 )          (51.6 )
Hedging impact:
Japanese Yen                 9.0             29.4
EMEA                         1.5              3.5
Total hedging impact        10.5             32.9
Total impact         $      (7.5 )    $     (18.7 )

During the three and nine months ended August 30, 2013, the U.S. Dollar strengthened against the Japanese Yen causing revenue in Japan measured in U.S. . . .

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