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ADBE > SEC Filings for ADBE > Form 10-Q on 28-Mar-2014All Recent SEC Filings

Show all filings for ADOBE SYSTEMS INC

Form 10-Q for ADOBE SYSTEMS INC


28-Mar-2014

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 U.S. Securities and Exchange Commission ("the SEC"), including our Annual Report on Form 10-K for fiscal 2013. When used in this report, the words "will," "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, except as required by law.
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 or a managed services model (both of which are referred to 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 2014, we reported financial results consistent with the continued execution of our long-term 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 our Digital Media segment, we are a market leader with Creative Cloud, our subscription-based offering for creating and publishing content and applications. Creative Cloud, first delivered in May 2012, is our next-generation offering that supersedes our historical model of licensing our creative products with perpetual licenses. Creative Cloud delivers value through 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.

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 continue to expect this to drive higher long-term revenue growth through an expansion of our customer base by acquiring new users through a lower cost of entry and delivery of additional features and value, as well as keeping existing customers current on our latest release. This model drives our revenue to be more recurring and predictable as revenue is recognized ratably.

We continue to implement strategies that will accelerate awareness, consideration and purchase of subscriptions to our Creative Cloud offering. These strategies include increasing the value Creative Cloud users receive, as well as targeted promotions


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and offers that attract past customers and potential users to try out and ultimately subscribe to Creative Cloud. Additionally, 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. More recently, we announced the removal of general availability of CS6 on a perpetual licensing basis from legacy shrinkwrap and volume licensing channels. We will still offer CS6 through our Adobe.com website and in certain markets.

Because of the shift towards Creative Cloud subscriptions and ETLAs, we have stated we expect perpetual revenue for CS6 to sequentially decline, and in the second half of fiscal 2014 we expect revenue from perpetual licensing of our creative professional products to be immaterial.

Total Digital Media revenue declined during the first quarter of fiscal 2014 compared to the year ago period as adoption of our Creative Cloud subscription offering continued to increase while CS6 perpetual revenue continued to decline as expected. This resulted in a milestone where reported revenue from subscriptions and ETLA adoption exceeded that of perpetual licenses of our creative professional products for the first time during the first quarter of fiscal 2014.

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"). ARR should be viewed independently of revenue, deferred revenue and unbilled deferred revenue as ARR is a performance metric and is not intended to be combined with any of these items.

For our Creative business, we define Creative 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; plus

•twelve months of Adobe Digital Publishing Suite contract value where the revenue is ratably recognized.

We exited the first quarter fiscal 2014 with 1.844 million paid Creative Cloud subscriptions, up 28% from 1.439 million at the end fiscal 2013. Total Creative ARR exiting the first quarter of fiscal 2014 was $987.0 million, up from $801.0 million as of November 29, 2013.

Our Digital Media segment also includes our Document Services products and solutions, including Acrobat, Acrobat cloud services and EchoSign e-signing solution. In the first quarter of fiscal 2014 we continued to drive solid adoption of our Acrobat family of products primarily through license agreements with enterprise customers. During the first quarter of fiscal 2014, a higher percentage of these agreements were ETLAs, which like ETLAs with our creative customers, cause more revenue to be recognized over time rather than at the time of contract signing. This has caused a decline in Acrobat revenue which was partially offset by increases associated with our Acrobat cloud services and EchoSign during the first quarter of fiscal 2014.

We expect that the benefit of ETLAs will improve our growth potential over time. In addition to Acrobat, we also drove strong adoption of subscription based services including our Acrobat cloud services and EchoSign. Combined, adoption of Acrobat through ETLAs and our Document Services subscription offerings helped grow Document Services ARR to $164.0 million exiting the first quarter of fiscal 2014, up from $63.0 million at the end of the first quarter of fiscal 2013.

Total Digital Media ARR, which we define as the sum of Creative ARR and Document Services ARR, grew to $1.15 billion at the exit of the first quarter of fiscal 2014, up from $300.0 million at the end of the first quarter fiscal 2013, demonstrating the progress we have made with our transformation of our business to a more recurring, ratable and predictable revenue model.

We are a market leader in the fast-growing category addressed by our Digital Marketing segment. Our Adobe Marketing Cloud includes six solutions addressing the expanding needs of marketers, the newest of which is Adobe Campaign-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 increased 24% during the three months ended February 28, 2014 compared to the year ago period. Helping to drive this performance was strong adoption of our Adobe Experience Manager ("AEM") offering and the addition of Neolane in mid-third quarter of fiscal 2013.


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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 in this segment to be recurring. 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 overall Adobe Marketing Cloud reported revenue growth in the near term.

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, 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. There have been no significant changes in our critical accounting policies and estimates during the three months ended February 28, 2014, 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 29, 2013. 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 First Quarter of Fiscal 2014

• Consistent with our strategy, during the three months ended February 28, 2014, our subscription revenue as a percentage of total revenue increased to 42% compared with 22%, in the year ago period, as we transition more of our business to a subscription-based model.

• We exited the first quarter of fiscal 2014 with 1.844 million paid Creative Cloud subscriptions, up 28% from 1.439 million at the end of fiscal 2013.

• Total Digital Media ARR of approximately $1.15 billion as of February 28, 2014 increased by $207.0 million, or 22%, from $944.0 million as of November 29, 2013. The change in our Digital Media ARR is primarily due to increases in the number of paid Creative Cloud individual and team subscriptions and continued adoption of our enterprise Creative Cloud offering through our ETLAs.

• Adobe Marketing Cloud revenue of $267.0 million during the three months ended February 28, 2014 increased by $51.6 million, or 24% compared to the three months ended March 1, 2013. The increase was primarily due to strong adoption of our AEM offering and the addition of Neolane in the third quarter of fiscal 2013.

• Our total deferred revenue of $881.1 million as of February 28, 2014 increased by $52.3 million, or 6% from November 29, 2013, primarily due to increases in subscriptions, ETLAs and renewals for our Adobe Marketing Cloud services.

• Cost of revenue of $148.5 million during the three months ended February 28, 2014 decreased by $8.2 million, or 5%, compared to the three months ended March 1, 2013. The decrease is primarily due to a one-time charge associated with technology license arrangements during the three months ended March 1, 2013. This decline was offset by increased


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hosting and server costs associated with our subscription and SaaS offerings and costs associated with compensation and related benefits driven by additional headcount.

• Operating expenses of $772.9 million during the three months ended February 28, 2014 increased by $19.9 million, or 3%, compared to the three months ended March 1, 2013. The increase is primarily driven by costs associated with higher incentive compensation program achievement during the three months ended February 28, 2014.

• Net income of $47.0 million during the three months ended February 28, 2014 decreased by $18.1 million, or 28%, compared to the three months ended March 1, 2013. 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 $251.7 million during the three months ended February 28, 2014 decreased by $70.4 million, or 22%, compared to the three months ended March 1, 2013 primarily due to lower net income as discussed above, coupled with changes in trade receivables as compared to the first quarter of fiscal 2013.

Revenue for the Three Months Ended February 28, 2014 and March 1, 2013 (dollars

in millions)
                                  Three Months
                               2014          2013        % Change
Product                     $   471.4     $   675.8       (30 )%
Percentage of total revenue        47 %          67 %
Subscription                    423.6         224.3        89  %
Percentage of total revenue        42 %          22 %
Services and support            105.1         107.8        (3 )%
Percentage of total revenue        11 %          11 %
Total revenue               $ 1,000.1     $ 1,007.9        (1 )%

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.
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. Subscription revenue by reportable segment for the three months ended February 28, 2014 and March 1, 2013 are as follows (dollars in millions):

                              Three Months
                             2014       2013     % Change
Digital Media              $ 238.0    $  69.0       245 %
Digital Marketing            183.8      154.9        19 %
Print and Publishing           1.8        0.4       350 %
Total subscription revenue $ 423.6    $ 224.3        89 %

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.


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Segment Information (dollars in millions)

                                  Three Months
                               2014          2013        % Change
Digital Media               $   641.1     $   688.4        (7 )%
Percentage of total revenue        64 %          68 %
Digital Marketing               314.4         267.7        17  %
Percentage of total revenue        31 %          27 %
Print and Publishing             44.6          51.8       (14 )%
Percentage of total revenue         5 %           5 %
Total revenue               $ 1,000.1     $ 1,007.9        (1 )%

Digital Media

Revenue from Digital Media decreased $47.3 million during the three months ended February 28, 2014, as compared to the three months ended March 1, 2013, 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 includes our Creative Cloud, Creative Suite editions and CS point products, decreased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 due to continued customer adoption of Creative Cloud subscription offerings. Due to the recent change to remove the availability of CS6 on a perpetual licensing basis from certain sales channels, we continue to anticipate accelerated adoption of Creative Cloud for individuals, teams and enterprises, for which revenue is recognized over time. This change will continue to cause our traditional perpetual license revenue to decline.

Revenue associated with our other creative products decreased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 primarily due to decreases associated with distribution of third-party software via Flash Player downloads, offset in part by increases associated with the release of Adobe Lightroom 5 in December 2013 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 months ended February 28, 2014 as compared to the three months ended March 1, 2013. Unit average selling prices for our perpetual units licensed decreased during the three months ended February 28, 2014 as compared to the same periods in the prior year.

Document Services revenue, which includes our Acrobat product family, increased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013. The increase in Document Services revenue was primarily due to higher revenue associated with our Acrobat cloud service and EchoSign. These increases were slightly offset by the effects of the continued shift to ETLAs.

Within Document Services, excluding large enterprise license agreement deals, the number of units licensed decreased while the unit average selling prices increased for the three months ended February 28, 2014, as compared to the three months ended March 1, 2013.

Digital Marketing

Revenue from Digital Marketing increased $46.7 million during the three months ended February 28, 2014, as compared to the three months ended March 1, 2013. The increases were primarily due to continued revenue growth associated with our Adobe Marketing Cloud, which increased 24% during the three months ended February 28, 2014, as compared to the year ago period. Contributing to this increase was strong adoption of all of our Digital Marketing offerings, particularly AEM, and the addition of Neolane which we acquired in the third quarter of fiscal 2013.
Print and Publishing

Revenue from Print and Publishing decreased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013, primarily due to decreases in legacy product revenue and, to a lesser extent, increased ETLAs for some products in this group.


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Geographical Information (dollars in millions)

                                  Three Months
                               2014          2013        % Change
Americas                    $   536.6     $   500.3         7  %
Percentage of total revenue        54 %          50 %
EMEA                            299.8         297.5         1  %
Percentage of total revenue        29 %          30 %
APAC                            163.7         210.1       (22 )%
Percentage of total revenue        17 %          20 %
Total revenue               $ 1,000.1     $ 1,007.9        (1 )%

Overall revenue during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 increased in the Americas and EMEA and declined in APAC. Revenue in the Americas increased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 due to increases in Digital Media and Digital Marketing, partially offset by declines in Print and Publishing. Revenue in EMEA increased slightly during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 due to increases in Digital Marketing, offset by declines in Digital Media and Print and Publishing. Revenue in APAC decreased across all reportable segments during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 which was due in part to the weakening of the Japanese Yen against the U.S. Dollar. 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 February 28, 2014 as compared to the three months ended March 1, 2013 were impacts associated with foreign currency as shown below.

(in millions)                  2014
Revenue impact:         Increase/(Decrease)
EMEA:
Euro                 $               4.5
British Pound                        1.0
Other currencies                     0.1
Total EMEA                           5.6
Japanese Yen                       (13.2 )
Other currencies                    (3.3 )
Total revenue impact               (10.9 )
Hedging impact:
Japanese Yen                         2.8
Total impact         $              (8.1 )

During the three months ended February 28, 2014, the U.S. Dollar strengthened against the Japanese Yen and other Asian currencies causing revenue in APAC measured in U.S. Dollar equivalents to decrease compared with the same reporting period last year. This decrease was partially offset by the favorable impact to revenue measured in EMEA currencies as the U.S. Dollar weakened against the Euro and the British Pound. Our Yen currency hedging programs resulted in hedging gains during the three months ended February 28, 2014.


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Cost of Revenue for the Three Months Ended February 28, 2014 and March 1, 2013
(dollars in millions)
                                Three Months
                              2014        2013       % Change
Product                     $  27.5     $  52.0       (47 )%
Percentage of total revenue       3 %         5 %
Subscription                   76.7        62.6        23  %
Percentage of total revenue       8 %         6 %
Services and support           44.3        42.1         5  %
Percentage of total revenue       4 %         4 %
Total cost of revenue       $ 148.5     $ 156.7        (5 )%

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 decreased during the three months ended February 28, 2014 as compared to the three months ended March 1, 2013 due to the following:

% Change
2014-2013
                                                                                  QTD
Amortization of purchased intangibles and technology license arrangements          (50 )%
Excess and obsolete inventory                                                        8
Various individually insignificant items                                            (5 )
Total change                                                                       (47 )%


Amortization of purchased intangibles and technology license arrangements
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