UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_________________________

 

FORM 10-Q

(Mark One)

 or

For the transition period from                   to                   

 

Commission File Number: 0-15175

 

(Exact name of registrant as specified in its charter)

_________________________

345 Park Avenue, San Jose, California 95110-2704

(Address of principal executive offices and zip code)

(408) 536-6000

(Registrant’s telephone number, including area code)

 _________________________

 

The number of shares outstanding of the registrant’s common stock as of June 22,September 21, 2018 was 489,662,656.488,133,527.

ADOBE SYSTEMS INCORPORATED

FORM 10-Q

 

TABLE OF CONTENTS

 

 

PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

  See accompanying notes to condensed consolidated financial statements.

(Unaudited)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 

(Unaudited)

NOTE 1.  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

We have prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Pursuant to these rules and regulations, we have condensed or omitted certain information and footnote disclosures we normally include in our annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In management’s opinion, we have made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present our financial position, results of operations and cash flows. Our interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 1, 2017 on file with the SEC (our “Annual Report”).

Recently Adopted Accounting Guidance

On January 26, 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2017-04, Simplifying the Test for Goodwill Impairment, which eliminated step two from the goodwill impairment test. In assessing impairment of goodwill, if it is concluded that it is more likely than not that the carrying amount of a reportable segment exceeds its fair value during the qualitative assessment, a one-step goodwill impairment test will be performed. If it is concluded during the quantitative test that the carrying amount of a reportable segment exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reportable segment. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted.

In the first quarter of 2018, we early adopted ASU 2017-04. The standard did not have an impact to our qualitative assessment for goodwill impairment that we performed in the second quarter of fiscal 2018.

Significant Accounting Policies

There have been no other material changes to our significant accounting policies during the sixnine months ended June 1,August 31, 2018, as compared to the significant accounting policies described in our Annual Report.

Recent Accounting Pronouncements Not Yet Effective

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in GAAP when it becomes effective and permits the use of either the full retrospective or modified retrospective transition method. The updated standard is effective for us in the first quarter of fiscal 2019. We expect to adopt this updated standard in the first quarter of fiscal 2019 on a modified retrospective basis. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

While we are continuing to assess all potential impacts of the new standard, we believe there should not be a material change to the amount of consolidated revenues on an annual basis.

We expect revenue related to our cloud offerings, including Creative Cloud and Document Cloud for business enterprises, individuals and teams, to remain substantially unchanged. When sold with cloud-enabled services, Creative Cloud and Document Cloud require a significant level of integration and interdependency with software and the individual components are not considered distinct. Revenue for these offerings will continue to be recognized over the period in which the cloud services are provided.

We believe the most significant revenue-related impact relates to our accounting for arrangements that include on-premise term-based software licenses bundled with maintenance and support. Under current GAAP, the revenue attributable to these software licenses is recognized ratably over the term of the arrangement because vendor-specific objective evidence (“VSOE”) does not exist for the undelivered maintenance and support element as it is not sold separately. The requirement to have VSOE for undelivered elements to enable the separation of revenue for the delivered software licenses is eliminated under the new standard. Accordingly, under the new standard we will be required to recognize as revenue a portion of the arrangement fee upon delivery of the software

Other expected impacts to our policies and disclosures include: earlier recognition of revenue for certain contracts due to the elimination of contingent revenue limitations, an unbilled receivable balance on our balance sheets, the requirement to estimate variable consideration for certain arrangements, increased allocation of revenue to and from professional services and other offerings, and changes to our financial statement disclosures such as remaining performance obligations.

Under current GAAP, we expense costs related to the acquisition of revenue-generating contracts as incurred. Under the new standard, we will be required to capitalize certain costs incremental to contract acquisition and amortize them over the expected period of benefit. There may be a material balance sheet impact at the period of adoption to capitalize costs of obtaining the contract as an asset, with a corresponding adjustment to opening retained earnings at the date of initial adoption. Additionally, we may have to record related deferred income taxes. We continue to evaluate the magnitude of the impact and the period over which these capitalized costs will be amortized.

Due to the complexity of certain of our contracts, the actual accounting treatment required under the new standard for these arrangements may be dependent on contract-specific terms and therefore may vary in some instances.

On February 24, 2016, the FASB issued ASU No. 2016-02, Leases, requiring lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases with a lease term of twelve months or less. For lessees, leases will continue to be classified as either operating or finance leases in the income statement. Lessor accounting is similar to the current model but updated to align with certain changes to the lessee model. Lessors will continue to classify leases as operating, direct financing or sales-type leases. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requiresallows for the application of the new guidance at the beginning of the earliest comparative period presented.presented or at the adoption date. The updated standard is effective for us beginning in the first quarter of fiscal 2020 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

On August 28, 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging, requiring expanded hedge accounting for both non-financial and financial risk components and refining the measurement of hedge results to better reflect an entity's hedging strategies. The updated standard also amends the presentation and disclosure requirements and changes how entities assess hedge effectiveness. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition with a cumulative effect adjustment recorded to opening retained earnings as of the initial adoption date. The updated standard is effective for us beginning in the first quarter of fiscal 2020 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

With the exception of the new standards discussed above, there have been no other recent accounting pronouncements or changes in accounting pronouncements during the sixnine months ended June 1,August 31, 2018, as compared to the recent accounting pronouncements described in our Annual Report, that are of significance or potential significance to us.

NOTE 2. ACQUISITIONS

On December 19, 2016, we completed our acquisition of TubeMogul, a publicly held video advertising platform company. Under the acquisition method of accounting, the total purchase price was allocated to TubeMogul’s net tangible and intangible assets based upon their estimated fair values as of December 19, 2016. The total final purchase price for TubeMogul was $560.8

Proforma financial information has not been presented for this acquisition as the impact of the acquisitions discussed above was not material to our condensed consolidated financial statements was not material.statements.

Subsequent to June 1,August 31, 2018, we completed our acquisition of Magento Commerceentered into a definitive agreement to acquire Marketo, Inc. (“Magento”Marketo”), a privately-held commercemarketing cloud platform company, for approximately $1.68$4.75 billion, subject to customary purchase price adjustments. The transaction is subject to regulatory approvals and customary closing conditions and is expected to close in cash consideration, as well as the assumptionfourth quarter of certain employee equity awards. The initial purchase accounting for this transaction has not yet been completed givenour fiscal 2018. Following the short period of time between the acquisition date and the issuance of these financial statements. Magento will be integratedclosing, we intend to integrate Marketo into our Digital Experience reportable segment for financial reporting purposes in the third quarter of fiscal 2018.purposes.

Cash equivalents consist of instruments with remaining maturities of three months or less at the date of purchase. We classify all of our cash equivalents and short-term investments as “available-for-sale.” In general, these investments are free of trading restrictions. We carry these investments at fair value, based on quoted market prices or other readily available market information. Unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our condensed consolidated balance sheets. Gains and losses are recognized when realized in our condensed consolidated statements of income. When we have determined that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to a credit loss is recognized in income. Gains and losses are determined using the specific identification method.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

Cash, cash equivalents and short-term investments consisted of the following as of December 1, 2017 (in thousands):

There were 1,210767 securities and 894 securities in an unrealized loss position for less than twelve months at June 1,August 31, 2018 and at December 1, 2017, respectively.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

There were 331197 securities and 360 securities in an unrealized loss position for more than twelve months at June 1,August 31, 2018 and at December 1, 2017, respectively.

We review our debt securities classified as short-term investments on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. We consider factors such as the length of time and extent to which the market value has been less than the cost, the financial condition and near-term prospects of the issuer and our intent to sell, or whether it is more likely than not we will be required to sell the investment before recovery of the investment’s amortized cost basis. If we believe that an other-than-temporary decline exists in one of these securities, we write down these investments to fair value. The portion of the write-down related to credit loss would be recorded to interest and other income, net in our condensed consolidated statements of income. Any portion not related to credit loss would be recorded to accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our condensed consolidated balance sheets. During the sixnine months ended June 1,August 31, 2018 and June 2,September 1, 2017, we did not consider any of our investments to be other-than-temporarily impaired.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis

We measure certain financial assets and liabilities at fair value on a recurring basis. There have been no transfers between fair value measurement levels during the sixnine months ended June 1,August 31, 2018.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

See Note 3 for further information regarding the fair value of our financial instruments. 

Our fixed income available-for-sale debt securities consist of high quality, investment grade securities from diverse issuers with a weighted average credit rating of AA-.A+. We value these securities based on pricing from independent pricing vendors who use matrix pricing valuation techniques including market approach methodologies that model information generated by market transactions involving identical or comparable assets, as well as discounted cash flow methodologies. Inputs include quoted prices in active markets for identical assets or inputs other than quoted prices that are observable either directly or indirectly in determining fair value, including benchmark yields, issuer spreads off benchmark yields, interest rates and U.S. Treasury or swap curves. We therefore classify all of our fixed income available-for-sale securities as Level 2. We perform routine procedures such as comparing prices obtained from multiple independent sources to ensure that appropriate fair values are recorded.

The fair values of our money market mutual funds and time deposits are based on the closing price of these assets as of the reporting date. We classify our money market mutual funds and time deposits as Level 1.

Our Level 2 over-the-counter foreign currency and interest rate swap derivatives are valued using pricing models and discounted cash flow methodologies based on observable foreign exchange and interest rate data at the measurement date.

Our deferred compensation plan assets consist of money market mutual funds and other mutual funds.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

We also have direct investments in privately held companies accounted for under the cost and equity method, which are periodically assessed for other-than-temporary impairment. If we determine that an other-than-temporary impairment has occurred, we write down the investment to its fair value. We estimate fair value of our cost and equity method investments considering available information such as pricing in recent rounds of financing, current cash positions, earnings and cash flow forecasts, recent operational performance and any other readily available market data. For the three and sixnine months ended June 1,August 31, 2018 and June 2,September 1, 2017, we determined there were no other-than-temporary impairments of our cost and equity method investments.

Hedge Accounting and Hedging Programs

We recognize derivative instruments and hedging activities as either assets or liabilities in our condensed consolidated balance sheets and measure them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting.

We evaluate hedge effectiveness at the inception of the hedge prospectively as well as retrospectively, and record any ineffective portion of the hedging instruments in interest and other income (expense), net on our condensed consolidated statements of income. The net gain (loss) recognized in interest and other income (expense), net for cash flow hedges due to hedge ineffectiveness was insignificant for all fiscal years presented. The time value of purchased contracts is recorded in interest and other income (expense), net in our condensed consolidated statements of income.

The bank counterparties to these contracts expose us to credit-related losses in the event of their nonperformance which are largely mitigated with collateral security agreements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. In addition, we enter into master netting arrangements which have the ability to further limit credit-related losses with the same counterparty by permitting net settlement of transactions.

We also hedge our net recognized foreign currency denominated assets and liabilities with foreign exchange forward contracts to reduce the risk that the value of these assets and liabilities will be adversely affected by changes in exchange rates. These contracts hedge assets and liabilities that are denominated in foreign currencies and are carried at fair value with changes in the fair value recorded to interest and other income (expense), net in our condensed consolidated statements of income. These contracts do not subject us to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the assets and liabilities being hedged.

Cash Flow Hedging—Hedges of Forecasted Foreign Currency Revenue and Interest Rate Risk

In countries outside the United States, we transact business in U.S. Dollars and in various other currencies. We may use foreign exchange option contracts or forward contracts to hedge certain cash flow exposures resulting from changes in these foreign currency exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge a portion of our forecasted foreign currency denominated revenue in the normal course of business and accordingly, they are not speculative in nature.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge, and the hedges must be highly effective in offsetting changes to future cash flows on hedged transactions. We record changes in the intrinsic value of these cash flow hedges in accumulated other comprehensive income (loss) in our condensed consolidated balance sheets, until the forecasted transaction occurs. When the forecasted transaction occurs, we reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income (loss) to interest and other income (expense), net in our condensed consolidated statements of income at that time. If we do not elect hedge accounting, or the contract does not qualify for hedge accounting treatment, the changes in fair value from period to period are recorded in interest and other income (expense), net in our condensed consolidated statements of income.

The interest rate swaps are accounted for as fair value hedges and substantially offset the changes in fair value of the hedged portion of the underlying debt that are attributable to the changes in market risk. Therefore, the gains and losses related to changes in the fair value of the interest rate swaps are included in interest and other income (expense), net in our condensed consolidated statements of income. The fair value of the interest rate swaps is reflected in other liabilities or other assets in our condensed consolidated balance sheets.

The fair value of derivative instruments on our condensed consolidated balance sheets as of June 1,August 31, 2018 and December 1, 2017 were as follows (in thousands):

ADOBE SYSTEMS INCORPORATED

(Unaudited)

The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our condensed consolidated statements of income for the three and sixnine months ended June 1,August 31, 2018 was as follows (in thousands):

The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our condensed consolidated statements of income for the three and sixnine months ended June 2,September 1, 2017 was as follows (in thousands):

ADOBE SYSTEMS INCORPORATED

(Unaudited)

NOTE 6.  GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Goodwill as of June 1,August 31, 2018 and December 1, 2017 was $7.14 billion and $5.82 billion, for both periods. During the six months ended June 1, 2018, decreasesrespectively. The increase was primarily due to foreign currency translation adjustments were offset byour acquisition of Magento in the increase from an immaterial acquisition. During the secondthird quarter of fiscal 2018, we completed our annual goodwill impairment test associated with our reporting units and determined there was no impairment of goodwill.2018.

Amortization expense related to purchased and other intangible assets was $34.6$47.0 million and $68.5$115.5 million for the three and sixnine months ended June 1,August 31, 2018, respectively. Comparatively, amortization expense related to purchased and other intangible assets was $39.1 million and $77.2$116.3 million for the three and sixnine months ended June 2,September 1, 2017, respectively. Of these amounts, $17.4$23.1 million and $34.0$57.1 million were included in cost of sales for the three and sixnine months ended June 1,August 31, 2018, respectively, and $19.5 million and $38.2$57.7 million the three and sixnine months ended June 2,September 1, 2017, respectively.

As of June 1,August 31, 2018, we expect amortization expense in future periods to be as follows (in thousands):

ADOBE SYSTEMS INCORPORATED

(Unaudited)

Accrued expenses as of June 1,August 31, 2018 and December 1, 2017 consisted of the following (in thousands):

Accrued media costs primarily relate to our advertising platform offerings which are part of the Advertising Cloud. We accrue for media costs related to impressions purchased from third-party ad inventory sources. Other primarily includes general corporate accruals for local and regional expenses. Other is also comprised of deferred rent related to office locations with rent escalations and foreign currency liability derivatives.

NOTE 8.  INCOME TAXES

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law, which significantly changes existing U.S. tax law and includes many provisions applicable to us, such as reducing the U.S. federal statutory tax rate, imposing a one-time transition tax on deemed repatriation of deferred foreign income, and adopting a territorial tax system. The Tax Act reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. For fiscal 2018, our blended U.S. federal statutory tax rate is 22.2%. This is the result of using the tax rate of 35% for the first month of fiscal 2018 and the reduced tax rate of 21% for the remaining eleven months of fiscal 2018. The Tax Act also required us to incur a one-time transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income, in each case reduced by certain foreign tax credits. The Tax Act also includes a provision to tax global intangible low-taxed income of foreign subsidiaries, a special tax deduction for foreign-derived intangible income, and a base erosion anti-abuse tax measure that may tax certain payments between a U.S. corporation and its subsidiaries. These additional provisions of the Tax Act will be effective for us beginning December 1, 2018.

The Tax Act was effective in the first quarter of our fiscal 2018. As of June 1,August 31, 2018, we have not completed our accounting for the tax effects of the Tax Act. During the quarter, we recorded an adjustment to the provisional tax charge based on reasonable estimates for those tax effects using the current available information and technical guidance on the interpretations of the Tax Act. In order to complete our accounting for the impact of the Tax Act, we continue to obtain, analyze and interpret additional guidance as such guidance becomes available from the U.S. Treasury Department, the Internal Revenue Service (“IRS”), state taxing jurisdictions, the FASB, and other standard-setting and regulatory bodies. New guidance or interpretations may materially impact our provision for income taxes in future periods. Additional information that is needed to complete the analysis but is currently unavailable includes, but is not limited to, the amount of earnings of certain subsidiaries as well as the amount of foreign taxes paid on such earnings for our fiscal 2018, the final determination of certain net deferred tax assets subject to remeasurement and when the related temporary differences will be settled or realized, and the tax treatment of such provisions of the Tax Act by various state tax authorities. In addition, we do not currently have sufficient information and guidance to determine the impact of certain changes to the taxation of our foreign earnings that will become effective for us in fiscal 2019. The provisional accounting impacts may change in futurethe subsequent reporting periods untilperiod when our accounting analysis is finalized, which will occur no later than one year from the enactment date, as permitted by SEC Staff Accounting Bulletin 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act.

ADOBE SYSTEMS INCORPORATED

(Unaudited)

As a result of the reduction in the federal corporate tax rate, we remeasured our deferred taxes as of the date of enactment of the Tax Act and recorded a provisional tax charge of $10 million based on the tax rate that is expected to apply when such deferred taxes are settled or realized in future periods. We have not completed our accounting for the measurement of deferred taxes. To calculate the remeasurement of deferred taxes, we estimated when the existing deferred taxes will be settled or realized. The remeasurement of deferred taxes included in our financial statements will be subject to further revisions if our current estimates are different from our actual future operating results.

As part of the adoption of a new territorial tax system we recorded a provisional transition tax expense of $118 million on deferred foreign earnings, which was comprised of $86 million for fiscal 2018 plus other ancillary effects recorded in the first fiscal quarter, long-term income taxes payable of $533 million, and a reduction in our deferred tax liability of $415 million. As a result of a change to our corporate tax structure that provided us the ability to deduct more expenses against our earnings in the U.S., we updated our Tax Act calculation during the three months ended June 1, 2018. This included an additional provisional transition tax expense of $28 million on deferred foreign earnings, a decrease of deferred tax assets by $72 million which also included utilization of credits that we estimate will be available to reduce the transition tax, and a reduction of long-term income tax payable by $44 million. As a result of technical guidance updates on the interpretations of the Tax Act available in the quarter, we updated our Tax Act calculation during the three months ended August 31, 2018. The application of this guidance resulted in an additional net provisional tax expense of $24 million, a decrease of net deferred tax assets by $25 million, an increase in unrecognized tax benefits included in the long-term income tax payable of $69 million, a reduction of the short-term income taxes payable of $7 million, and a reduction to the long-term income tax payable of $62 million. To calculate the transition tax, we estimated our deferred foreign income for fiscal 2017 and 2018 because these tax returns arethe information needed to complete the calculation will not complete or due. The fiscal 2017 and fiscal 2018be known until our taxable income will be known once the respective tax returns are completed and filed.is known. In addition, U.S. and foreign audit settlements may significantly impact the estimated transition tax. The impact of the U.S. and foreign audits on the transition tax will be known as the audits are concluded. We intend to elect to pay the federal transition tax over a period of eight years as permitted by the Tax Act. As a result, in the second quarter of fiscal 2018, we reclassified $39 million from long-term income taxes payable to short-term income taxes payable for the first installment payment due in fiscal 2019. During the three months ended August 31, 2018, we reclassified $5 million from short-term income taxes payable to long-term income taxes payable as a result of the updated technical guidance on the interpretations of the Tax Act.

Certain international provisions introduced in the Tax Act will be effective for us in fiscal 2019. We need additional information to complete our analysis on whether to adopt an accounting policy to account for the tax effects of these provisions in the period that it is subject to such tax, or to provide deferred taxes for book and tax basis differences that upon reversal may be subject to these taxes. Accordingly, we have not recorded any tax with respect to these provisions in the sixnine months ended June 1,August 31, 2018. We will make an accounting policy election and complete the required accounting no later than the first quarter of fiscal 2019.

NOTE 9.  STOCK-BASED COMPENSATION

Summary of Restricted Stock Units

Restricted stock unit activity for the sixnine months ended June 1,August 31, 2018 and the fiscal year ended December 1, 2017 was as follows (in thousands):

ADOBE SYSTEMS INCORPORATED

(Unaudited)

Information regarding restricted stock units outstanding at June 1,August 31, 2018 and June 2,September 1, 2017 is summarized below: