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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, market opportunities, fluctuations in foreign currency exchange rates, strategic investments, industry positioning, customer acquisition and retention, the amount of annualized recurring revenue, revenue growth and anticipated impacts on our business of the ongoing COVID-19 pandemic and related public health measures. In addition, 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. Each of the forward-looking statements we make in this report involves 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 titled “Risk Factors” in Part II, Item 1A of this report. 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 2021, should be carefully reviewed. Undue reliance should not be placed 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 is one of the largest and most diversified software companies in the world. We offer a line of products and services used by creative professionals, including photographers, video editors, graphic and experience designers and game developers; communicators, including content creators, students, marketers and knowledge workers; businesses of all sizes; and consumers for creating, managing, delivering, measuring, optimizing, engaging and transacting with compelling content and experiences across personal computers, smartphones, other electronic devices and digital media formats.
We market our products and services directly to enterprise customers through our sales force and local field offices. We license our products to end users through app stores and our own website at www.adobe.com. We offer many of our products via a Software-as-a-Service (“SaaS”) model or a managed services model (both of which are referred to as hosted or cloud-based) as well as through term subscription and pay-per-use models. We also distribute certain products and services through a network of distributors, value-added resellers, systems integrators, independent software vendors, retailers, software developers 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. Our products run on desktop and laptop computers, smartphones, tablets, other devices and the web, depending on the product. We have operations in the Americas; Europe, Middle East and Africa (“EMEA”); and Asia-Pacific (“APAC”).
Adobe was originally incorporated in California in October 1983 and was reincorporated in Delaware in May 1997. Our executive offices and principal facilities are located at 345 Park Avenue, San Jose, California 95110-2704. Our telephone number is 408-536-6000 and our website is www.adobe.com. Investors can obtain copies of our SEC filings from our website free of charge, as well as from the SEC website at www.sec.gov. The information posted to our website is not incorporated into this Quarterly Report on Form 10-Q.
OPERATIONS OVERVIEW
For our third quarter of fiscal 2022, we experienced strong demand across our Digital Media and Digital Experience offerings, driven by the ongoing shift towards a digital-first world. As we execute on our long-term growth initiatives, we have continued to experience growth in software-based subscription revenue across our portfolio of offerings.
Digital Media
In our Digital Media segment, we are a market leader with Creative Cloud, our subscription-based offering which provides desktop tools, mobile apps and cloud-based services for designing, creating and publishing rich content and immersive 3D experiences. Starting in December 2021, Creative Cloud includes Adobe Express, a web and mobile application designed to enable a broad spectrum of users, including novice content creators, communicators and creative professionals, to create, edit and customize content quickly and easily with content-first, task-based solutions. Creative Cloud delivers value with deep, cross-product integration, frequent product updates and feature enhancements, cloud-enabled services including storage and syncing of files across users’ machines, machine learning and artificial intelligence, access to marketplace, social and
community-based features with our Adobe Stock and Behance services, app creation capabilities, tools which assist with enterprise deployments and team collaboration, and affordable pricing for cost-sensitive customers.
We offer Creative Cloud for individuals, students, teams and enterprises. We expect Creative Cloud will drive sustained long-term revenue growth through a continued expansion of our customer base by attracting new users with new features and products like Adobe Express that make creative tools accessible to first-time creators and communicators, continuing to acquire users with low cost of entry and delivery of additional features and value to Creative Cloud, and delivering new features and technologies to existing customers with our latest releases. We have also built out a marketplace for Creative Cloud subscribers to enable the delivery and purchase of stock content in our Adobe Stock service. Overall, our strategy with Creative Cloud is designed to enable us to increase our revenue with users, attract more new customers, and grow our recurring and predictable revenue stream that is recognized ratably.
We continue to implement strategies that are designed to accelerate awareness, consideration and purchase of subscriptions to our Creative Cloud offerings. These strategies include increasing the value Creative Cloud users receive, such as offering new desktop and mobile applications, as well as targeted promotions and offers that attract past customers and potential users to experience and ultimately subscribe to Creative Cloud. Because of the shift towards Creative Cloud subscriptions and Enterprise Term License Agreements (“ETLAs”), revenue from perpetual licensing of our Creative products has been immaterial to our business.
We are also a market leader with our Document Cloud offerings built around our Adobe Acrobat family of products, with a set of integrated mobile apps and cloud-based document services which enable users to create, review, approve, sign and track documents regardless of platform or application source type. Document Cloud, which enhances the way people manage critical documents at home, in the office and across devices, includes Adobe Acrobat, Adobe Acrobat Sign and Adobe Scan. Adobe Acrobat is offered both through subscription and perpetual licenses.
As part of our Creative Cloud and Document Cloud strategies, we utilize a data-driven operating model (“DDOM”) and our Adobe Experience Cloud solutions to raise awareness of our products, drive new customer acquisition, engagement and retention, and optimize customer journeys, and it continues to contribute strong growth in the business.
Annualized Recurring Revenue (“ARR”) is currently the key performance metric our management uses to assess the health and trajectory of our overall Digital Media segment. ARR should be viewed independently of revenue, deferred revenue and remaining performance obligations as ARR is a performance metric and is not intended to be combined with any of these items. We adjust our reported ARR on an annual basis to reflect any exchange rate changes. Our reported ARR results in the current fiscal year are based on currency rates set at the beginning of the year and held constant throughout the year. We calculate ARR as follows:
| Creative ARR | Annual Value of Creative Cloud Subscriptions and Services + Annual Creative ETLA Contract Value | |||||||
| Document Cloud ARR | Annual Value of Document Cloud Subscriptions and Services + Annual Document Cloud ETLA Contract Value | |||||||
| Digital Media ARR | Creative ARR + Document Cloud ARR |
In March 2022, in response to the Russia-Ukraine war, we announced a halt of all new sales of our products and services in Russia and Belarus. As a result, we reduced our Digital Media ARR balance by $75 million, which represented our Digital Media ARR for existing business in Russia and Belarus. While we continued to provide Digital Media services in Ukraine, we also reduced our Digital Media ARR balance by an additional $12 million, which represented our Digital Media business in Ukraine. This resulted in a total ARR reduction of $87 million taken at the beginning of the second quarter of fiscal 2022.
Creative ARR exiting the third quarter of fiscal 2022 was $11.15 billion, up from $10.22 billion at the end of fiscal 2021. Document Cloud ARR exiting the third quarter of fiscal 2022 was $2.25 billion, up from $1.93 billion at the end of fiscal 2021. Total Digital Media ARR grew to $13.40 billion at the end of the third quarter of fiscal 2022, up from $12.15 billion at the end of fiscal 2021.
Our success in driving growth in ARR has positively affected our revenue growth. Creative revenue in the third quarter of fiscal 2022 was $2.63 billion, up from $2.37 billion in the third quarter of fiscal 2021, representing 11% year-over-year
growth. Document Cloud revenue in the third quarter of fiscal 2022 was $607 million, up from $493 million in the third quarter of fiscal 2021, representing 23% year-over-year growth. Total Digital Media segment revenue grew to $3.23 billion in the third quarter of fiscal 2022, up from $2.87 billion in the third quarter of fiscal 2021, representing 13% year-over-year growth driven by strong net new user growth.
Digital Experience
We are a market leader in the fast-growing category addressed by our Digital Experience segment. The Adobe Experience Cloud applications, services and platform are designed to manage customer journeys, enable shoppable experiences and deliver intelligence for businesses of any size in any industry. Our differentiation and competitive advantage are strengthened by our ability to use the Adobe Experience Platform to integrate our comprehensive set of solutions.
Adobe Experience Cloud delivers solutions for our customers across the following strategic growth pillars:
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Data insights and audiences. Our solutions, including Adobe Analytics, Adobe Experience Platform, Customer Journey Analytics, Adobe Audience Manager and our Real-time Customer Data Platform, deliver robust customer profiles and AI-powered analytics across the customer journey to provide timely, relevant experiences across platforms.
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Content and commerce. Our solutions help customers manage, deliver and optimize content delivery through Adobe Experience Manager, and to enable shopping experiences that scale from mid-market to enterprise businesses with Adobe Commerce.
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Customer journeys. Our solutions help businesses manage, test, target, personalize and orchestrate campaigns and customer journeys across B2E use cases, including through Marketo Engage, Adobe Campaign, Adobe Target and Journey Optimizer.
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Marketing workflow. We offer Adobe Workfront, a work management platform directed toward marketers to orchestrate campaign workflows.
In addition to chief marketing officers, chief revenue officers and digital marketers, users of our Digital Experience solutions include advertisers, campaign managers, publishers, data analysts, content managers, social marketers, marketing executives and information management and technology executives. These customers often are involved in workflows that utilize other Adobe products, such as our Digital Media offerings. By combining the creativity of our Digital Media business with the science of our Digital Experience business, we help our customers to more efficiently and effectively make, manage, measure and monetize their content across every channel with an end-to-end workflow and feedback loop.
We utilize a direct sales force to market and license our Digital Experience solutions, as well as an extensive ecosystem of partners, including marketing agencies, systems integrators and independent software vendors that help license and deploy our solutions to their customers. We have made significant investments to broaden the scale and size of all of these routes to market, and our recent financial results reflect the success of these investments.
Digital Experience revenue was $1.12 billion in the third quarter of fiscal 2022, up from $985 million in the third quarter of fiscal 2021, representing 14% year-over-year growth. Driving this increase was the increase in subscription revenue, which grew to $981 million in the third quarter of fiscal 2022 from $864 million in the third quarter of fiscal 2021, representing 14% year-over-year growth.
Macroeconomic Conditions
As a corporation with an extensive global footprint, we are subject to risks and exposures from foreign currency exchange rate fluctuations caused by significant events with macroeconomic impacts, including, but not limited to, the Russia-Ukraine war, COVID-19 pandemic and actions taken by central banks to counter inflation. We continuously monitor the direct and indirect impacts of these circumstances on our business and financial results, as well as the overall global economy and geopolitical landscape. Foreign currency exchange rate fluctuations have negatively impacted our revenue and earnings during the nine months ended September 2, 2022, and may continue to negatively impact our financial results in the fourth quarter of fiscal 2022.
While our revenue and earnings are relatively predictable as a result of our subscription-based business model, the broader implications of these macroeconomic events on our business, results of operations and overall financial position, particularly in the long term, remain uncertain. See Risk Factors for further discussion of the possible impact of these macroeconomic issues on our business.
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. We evaluate our assumptions, judgments and estimates on a regular basis. 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 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, and consequently, 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 nine months ended September 2, 2022, 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 December 3, 2021.
Recent Accounting Pronouncements
RESULTS OF OPERATIONS
Financial Performance Summary
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Total Digital Media ARR of approximately $13.40 billion as of September 2, 2022 increased by $1.24 billion, or 10%, from $12.15 billion as of December 3, 2021. The change in our Digital Media ARR is primarily due to new user adoption of our Creative Cloud and Document Cloud offerings, partially offset by an $87 million ARR reduction taken in March 2022 in response to the Russia-Ukraine war.
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Creative revenue during the three months ended September 2, 2022 of $2.63 billion increased by $253 million, or 11%, compared to the year-ago period. Document Cloud revenue during the three months ended September 2, 2022 of $607 million increased by $114 million, or 23%, compared to the year-ago period. The increases were primarily due to subscription revenue growth associated with our Creative Cloud and Document Cloud offerings.
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Digital Experience revenue of $1.12 billion during the three months ended September 2, 2022 increased by $135 million, or 14%, compared to the year-ago period. The increase was primarily due to subscription revenue growth across our offerings.
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Remaining performance obligations of $14.11 billion as of September 2, 2022 increased by $115 million, or 1%, from $13.99 billion as of December 3, 2021 primarily due to new contracts and renewals for our Digital Media offerings, partially offset by the impact of foreign currency exchange rate fluctuations.
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Cost of revenue of $546 million during the three months ended September 2, 2022 increased by $79 million, or 17%, compared to the year-ago period primarily due to increases in hosting services and data center costs, as well as increases in base and incentive compensation and related benefits costs.
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Operating expenses of $2.40 billion during the three months ended September 2, 2022 increased by $376 million, or 19%, compared to the year-ago period primarily due to increases in base and incentive compensation and related benefits costs, as well as increased marketing spend.
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Cash flows from operations of $5.51 billion during the nine months ended September 2, 2022 increased by $349 million, or 7%, compared to the year-ago period primarily due to higher net income adjusted for the net effect of non-cash items.
Revenue for the Three and Nine Months Ended September 2, 2022 and September 3, 2021
Revenue for the nine months ended September 3, 2021 benefited from an extra week in the first quarter of fiscal 2021 due to our 52/53 week financial calendar whereby fiscal 2022 is a 52-week year compared with fiscal 2021 which was a 53-week year.
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Subscription | $ | 4,128 | $ | 3,657 | 13 | % | $ | 12,156 | $ | 10,761 | 13 | % | |||||||||||||||||||||||
| Percentage of total revenue | 93 | % | 93 | % | 93 | % | 92 | % | |||||||||||||||||||||||||||
| Product | 126 | 119 | 6 | % | 417 | 427 | (2) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 3 | % | 3 | % | 3 | % | 4 | % | |||||||||||||||||||||||||||
| Services and other | 179 | 159 | 13 | % | 508 | 487 | 4 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 4 | % | 4 | % | 4 | % | 4 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,433 | $ | 3,935 | 13 | % | $ | 13,081 | $ | 11,675 | 12 | % |
Subscription
Our subscription revenue is comprised primarily of fees we charge for our subscription and hosted service offerings, and related support, including Creative Cloud and certain of our Adobe Experience Cloud and Document Cloud services. We primarily recognize subscription revenue ratably over the term of agreements with our customers, beginning with commencement of service. Subscription revenue related to certain offerings, where fees are based on a number of transactions and invoicing is aligned to the pattern of performance, customer benefit and consumption, are recognized on a usage basis.
We have the following reportable segments: Digital Media, Digital Experience, and Publishing and Advertising. Subscription revenue by reportable segment for the three and nine months ended September 2, 2022 and September 3, 2021 is as follows:
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Digital Media | $ | 3,116 | $ | 2,757 | 13 | % | $ | 9,190 | $ | 8,156 | 13 | % | |||||||||||||||||||||||
| Digital Experience | 981 | 864 | 14 | % | 2,874 | 2,493 | 15 | % | |||||||||||||||||||||||||||
| Publishing and Advertising | 31 | 36 | (14) | % | 92 | 112 | (18) | % | |||||||||||||||||||||||||||
| Total subscription revenue | $ | 4,128 | $ | 3,657 | 13 | % | $ | 12,156 | $ | 10,761 | 13 | % |
Product
Our product revenue is comprised primarily of fees related to licenses for on-premise software purchased on a perpetual basis, for a fixed period of time or based on usage for certain of our OEM and royalty agreements. We primarily recognize product revenue at the point in time the software is available to the customer, provided all other revenue recognition criteria are met.
Services and Other
Our services and other revenue is comprised primarily of fees related to consulting, training, maintenance and support for certain on-premise licenses that are recognized at a point in time and our advertising offerings. We typically sell our consulting contracts on a time-and-materials and fixed-fee basis. These revenues are recognized as the services are performed for time-and-materials contracts and on a relative performance basis for fixed-fee contracts. Training revenues are recognized as the services are performed. Our maintenance and support offerings, which entitle customers, partners and developers to receive desktop product upgrades and enhancements or technical support, depending on the offering, are generally recognized ratably over the term of the arrangement. Transaction-based advertising revenue is recognized on a usage basis as we satisfy the performance obligations to our customers.
Segment Information
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Digital Media | $ | 3,232 | $ | 2,865 | 13 | % | $ | 9,542 | $ | 8,511 | 12 | % | |||||||||||||||||||||||
| Percentage of total revenue | 73 | % | 73 | % | 73 | % | 73 | % | |||||||||||||||||||||||||||
| Digital Experience | 1,120 | 985 | 14 | % | 3,272 | 2,857 | 15 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 25 | % | 25 | % | 25 | % | 24 | % | |||||||||||||||||||||||||||
| Publishing and Advertising | 81 | 85 | (5) | % | 267 | 307 | (13) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 2 | % | 2 | % | 2 | % | 3 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,433 | $ | 3,935 | 13 | % | $ | 13,081 | $ | 11,675 | 12 | % |
Digital Media
Revenue by major offerings in our Digital Media reportable segment for the three and nine months ended September 2, 2022 and September 3, 2021 were as follows:
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Creative Cloud | $ | 2,625 | $ | 2,372 | 11 | % | $ | 7,778 | $ | 7,069 | 10 | % | |||||||||||||||||||||||
| Document Cloud | 607 | 493 | 23 | % | 1,764 | 1,442 | 22 | % | |||||||||||||||||||||||||||
| Total Digital Media revenue | $ | 3,232 | $ | 2,865 | 13 | % | $ | 9,542 | $ | 8,511 | 12 | % |
Revenue from Digital Media increased $367 million and $1.03 billion during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 driven by increases in revenue associated with our Creative and Document Cloud subscription offerings due to continued demand amid an increasingly digital environment and strong customer acquisition and engagement.
Digital Experience
Revenue from Digital Experience increased $135 million and $415 million during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to net new additions across our subscription offerings.
Geographical Information
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Americas | $ | 2,600 | $ | 2,242 | 16 | % | $ | 7,570 | $ | 6,651 | 14 | % | |||||||||||||||||||||||
| Percentage of total revenue | 59 | % | 57 | % | 58 | % | 57 | % | |||||||||||||||||||||||||||
| EMEA | 1,143 | 1,061 | 8 | % | 3,436 | 3,139 | 9 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 26 | % | 27 | % | 26 | % | 27 | % | |||||||||||||||||||||||||||
| APAC | 690 | 632 | 9 | % | 2,075 | 1,885 | 10 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 15 | % | 16 | % | 16 | % | 16 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,433 | $ | 3,935 | 13 | % | $ | 13,081 | $ | 11,675 | 12 | % |
Overall revenue during the three and nine months ended September 2, 2022 increased in all geographic regions as compared to the three and nine months ended September 3, 2021 primarily due to increases in Digital Media and Digital Experience revenue. Within each geographic region, the fluctuations in revenue by reportable segment were attributable to the factors noted in the segment information above.
Included in the overall change in revenue for the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 were impacts associated with foreign currency which were mitigated in part by our foreign currency hedging program. During the three and nine months ended September 2, 2022 as compared to the year-ago periods, the U.S. Dollar strengthened against foreign currencies, including the Euro and the Japanese Yen, which decreased revenue in U.S. Dollar equivalents by $156 million and $273 million, respectively. For the three and nine months ended
September 2, 2022, the foreign currency impacts to revenue were offset in part by net hedging gains from our cash flow hedging program of $54 million and $105 million, respectively.
Cost of Revenue for the Three and Nine Months Ended September 2, 2022 and September 3, 2021
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Subscription | $ | 413 | $ | 344 | 20 | % | $ | 1,216 | $ | 996 | 22 | % | |||||||||||||||||||||||
| Percentage of total revenue | 9 | % | 9 | % | 9 | % | 9 | % | |||||||||||||||||||||||||||
| Product | 8 | 10 | (20) | % | 27 | 29 | (7) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | * | * | * | * | |||||||||||||||||||||||||||||||
| Services and other | 125 | 113 | 11 | % | 354 | 333 | 6 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 3 | % | 3 | % | 3 | % | 3 | % | |||||||||||||||||||||||||||
| Total cost of revenue | $ | 546 | $ | 467 | 17 | % | $ | 1,597 | $ | 1,358 | 18 | % |
(*) Percentage is less than 1%.
Subscription
Cost of subscription revenue consists of third-party hosting services and data center costs, including expenses related to operating our network infrastructure. Cost of subscription revenue also includes compensation costs associated with network operations, implementation, account management and technical support personnel, royalty fees, software costs and amortization of certain intangible assets.
Cost of subscription revenue increased during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to the following:
| Components of % Change 2022-2021 QTD | Components of % Change 2022-2021 YTD | ||||||||||
| Hosting services and data center costs | 8 | % | 11 | % | |||||||
| Amortization of intangibles | 6 | 5 | |||||||||
| Base compensation and related benefits | 3 | 3 | |||||||||
| Incentive compensation, cash and stock-based | 1 | 1 | |||||||||
| Royalty costs | 2 | 2 | |||||||||
| Total change | 20 | % | 22 | % |
Product
Cost of product revenue is primarily comprised of third-party royalties, localization costs and the costs associated with the manufacturing of our products.
Services and Other
Cost of services and other revenue is primarily comprised of compensation and contracted costs incurred to provide consulting services, training and product support, and hosting services and data center costs.
Cost of services and other revenue increased during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to increases in professional fees and compensation costs.
Operating Expenses for the Three and Nine Months Ended September 2, 2022 and September 3, 2021
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Research and development | $ | 775 | $ | 651 | 19 | % | $ | 2,214 | $ | 1,883 | 18 | % | |||||||||||||||||||||||
| Percentage of total revenue | 17 | % | 17 | % | 17 | % | 16 | % | |||||||||||||||||||||||||||
| Sales and marketing | 1,266 | 1,068 | 19 | % | 3,671 | 3,190 | 15 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 29 | % | 27 | % | 28 | % | 27 | % | |||||||||||||||||||||||||||
| General and administrative | 319 | 265 | 20 | % | 879 | 811 | 8 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 7 | % | 7 | % | 7 | % | 7 | % | |||||||||||||||||||||||||||
| Amortization of intangibles | 43 | 43 | — | % | 127 | 132 | (4) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 1 | % | 1 | % | 1 | % | 1 | % | |||||||||||||||||||||||||||
| Total operating expenses | $ | 2,403 | $ | 2,027 | 19 | % | $ | 6,891 | $ | 6,016 | 15 | % |
Research and Development
Research and development expenses consist primarily of compensation and contracted costs associated with software development, third-party hosting services and data center costs, related facilities costs and expenses associated with computer equipment and software used in development activities.
Research and development expenses increased during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to the following:
| Components of % Change 2022-2021 QTD | Components of % Change 2022-2021 YTD | ||||||||||
| Incentive compensation, cash and stock-based | 8 | % | 7 | % | |||||||
| Base compensation and related benefits | 8 | 7 | |||||||||
| Professional and consulting fees | 1 | 2 | |||||||||
| Various individually insignificant items | 2 | 2 | |||||||||
| Total change | 19 | % | 18 | % |
Investments in research and development, including the recruiting and hiring of software developers, are critical to remain competitive in the marketplace and are directly related to continued timely development of new and enhanced offerings and solutions. We will continue to focus on long-term opportunities available in our end markets and make significant investments in the development of our subscription and service offerings, applications and tools.
Sales and Marketing
Sales and marketing expenses consist primarily of compensation costs, amortization of contract acquisition costs, including sales commissions, travel expenses and related facilities costs for our sales, marketing, order management and global supply chain management personnel. Sales and marketing expenses also include the costs of programs aimed at increasing revenue, such as advertising, trade shows and events, public relations and other market development programs.
Sales and marketing expenses increased during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to the following:
| Components of % Change 2022-2021 QTD | Components of % Change 2022-2021 YTD | ||||||||||
| Marketing spend related to campaigns, events and overall marketing efforts | 7 | % | 5 | % | |||||||
| Base compensation and related benefits | 5 | 4 | |||||||||
| Incentive compensation, cash and stock-based | 3 | 3 | |||||||||
| Professional and consulting fees | 2 | 2 | |||||||||
| Various individually insignificant items | 2 | 1 | |||||||||
| Total change | 19 | % | 15 | % |
General and Administrative
General and administrative expenses consist primarily of compensation and contracted costs, travel expenses and related facilities costs for our finance, facilities, human resources, legal, information services and executive personnel. General and administrative expenses also include outside legal and accounting fees, provision for bad debts, expenses associated with computer equipment and software used in the administration of the business, charitable contributions and various forms of insurance.
General and administrative expenses increased during the three and nine months ended September 2, 2022 as compared to the three and nine months ended September 3, 2021 primarily due to the following:
| Components of % Change 2022-2021 QTD | Components of % Change 2022-2021 YTD | ||||||||||
| Charitable contributions | 6 | % | 2 | % | |||||||
| Base compensation and related benefits | 5 | 3 | |||||||||
| Incentive compensation, cash and stock-based | 5 | 2 | |||||||||
| Bad debt expense | 3 | 1 | |||||||||
| Various individually insignificant items | 1 | — | |||||||||
| Total change | 20 | % | 8 | % |
Amortization of Intangibles
Amortization expenses decreased during the nine months ended September 2, 2022 as compared to the nine months ended September 3, 2021 primarily due to certain intangible assets from previous acquisitions becoming fully amortized in fiscal 2021. The decrease in amortization expense was partially offset by increases to amortization expense primarily associated with intangible assets purchased through our acquisition of Frame.io during the fourth quarter of fiscal 2021.
Non-Operating Income (Expense), Net for the Three and Nine Months Ended September 2, 2022 and September 3, 2021
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Interest expense | $ | (28) | $ | (27) | 4 | % | $ | (84) | $ | (85) | (1) | % | |||||||||||||||||||||||
| Percentage of total revenue | (1) | % | (1) | % | (1) | % | (1) | % | |||||||||||||||||||||||||||
| Investment gains (losses), net | (6) | 7 | ** | (23) | 20 | ** | |||||||||||||||||||||||||||||
| Percentage of total revenue | * | * | * | * | |||||||||||||||||||||||||||||||
| Other income (expense), net | 6 | (3) | ** | 5 | 1 | ** | |||||||||||||||||||||||||||||
| Percentage of total revenue | * | * | * | * | |||||||||||||||||||||||||||||||
| Total non-operating income (expense), net | $ | (28) | $ | (23) | ** | $ | (102) | $ | (64) | ** |
(*) Percentage is less than 1%.
(**) Percentage is not meaningful.
Interest Expense
Interest expense represents interest associated with our debt instruments. Interest on our senior notes is payable semi-annually, in arrears, on February 1 and August 1.
Investment Gains (Losses), Net
Investment gains (losses), net consists principally of unrealized holding gains and losses associated with our deferred compensation plan assets, and gains and losses associated with our direct and indirect investments in privately held companies.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest earned on cash, cash equivalents and short-term fixed income investments. Other income (expense), net also includes realized gains and losses on fixed income investments and foreign exchange gains and losses.
Provision for Income Taxes for the Three and Nine Months Ended September 2, 2022 and September 3, 2021
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2022 | 2021 | % Change | 2022 | 2021 | % Change | ||||||||||||||||||||||||||||||
| Provision for income taxes | $ | 320 | $ | 206 | 55 | % | $ | 911 | $ | 648 | 41 | % | |||||||||||||||||||||||
| Percentage of total revenue | 7 | % | 5 | % | 7 | % | 6 | % | |||||||||||||||||||||||||||
| Effective tax rate | 22 | % | 15 | % | 20 | % | 15 | % |
Our effective tax rates increased by approximately seven percentage points and five percentage points for the three and nine months ended September 2, 2022, respectively, as compared to the three and nine months ended September 3, 2021, primarily due to lower tax benefits related to stock-based compensation during the three and nine months ended September 2, 2022.
Our effective tax rate for the three months ended September 2, 2022 was higher than the U.S. federal statutory tax rate of 21% primarily due to the impact of state taxes, partially offset by the U.S. federal research tax credit. Our effective tax rate for the nine months ended September 2, 2022 was lower than the U.S. federal statutory tax rate of 21%, primarily due to the impact of the U.S. federal research tax credit and tax benefits related to stock-based compensation, partially offset by state taxes.
We recognize deferred tax assets to the extent that we believe these assets are more likely than not to be realized. In making such a determination, we considered all available positive and negative evidence, including our past operating results, forecasted earnings, future taxable income and prudent and feasible tax planning strategies. On the basis of this evaluation, we continue to maintain a valuation allowance to reduce our deferred tax assets to the amount realizable. The total valuation allowance was $427 million as of September 2, 2022, primarily attributable to certain state credits.
We are a United States-based multinational company subject to tax in multiple U.S. and foreign tax jurisdictions. The current U.S. tax law subjects the earnings of certain foreign subsidiaries to U.S. tax and generally allows an exemption from taxation for distributions from foreign subsidiaries.
In the current global tax policy environment, the U.S. Treasury and other domestic and foreign governing bodies continue to consider, and in some cases introduce, changes in regulations applicable to corporate multinationals such as Adobe. As regulations are issued, we account for finalized regulations in the period of enactment.
Accounting for Uncertainty in Income Taxes
The gross liabilities for unrecognized tax benefits excluding interest and penalties were $307 million and $289 million as of September 2, 2022 and September 3, 2021, respectively. If the total unrecognized tax benefits at September 2, 2022 and September 3, 2021 were recognized, $198 million and $204 million would decrease the respective effective tax rates.
As of September 2, 2022 and September 3, 2021, the combined amounts of accrued interest and penalties related to tax positions taken on our tax returns were approximately $14 million and $23 million, respectively. These amounts were included in long-term income taxes payable in their respective years.
The timing of the resolution of income tax examinations is highly uncertain as are the amounts and timing of tax payments that are part of any audit settlement process. These events could cause large fluctuations in the balance sheet classification of our tax assets and liabilities. We believe that within the next 12 months, it is reasonably possible that either certain audits will conclude or statutes of limitations on certain income tax examination periods will expire, or both. Given the uncertainties described above, we can only determine a range of estimated potential decreases in underlying unrecognized tax benefits ranging from $0 to approximately $15 million over the next 12 months.
In addition, in the United States and other countries where we conduct business and in jurisdictions in which we are subject to tax, including those covered by governing bodies that enact tax laws applicable to us, such as the European Commission of the European Union, we are subject to potential changes in relevant tax, accounting and other laws, regulations and interpretations, including changes to tax laws applicable to corporate multinationals such as Adobe. These countries, other governmental bodies and intergovernmental economic organizations such as the Organization for Economic Cooperation and Development, have or could make unprecedented assertions about how taxation is determined in their jurisdictions that are contrary to the way in which we have interpreted and historically applied the rules and regulations described above in such jurisdictions. In the current global tax policy environment, any changes in laws, regulations and interpretations related to these assertions could adversely affect our effective tax rates, cause us to respond by making changes to our business structure, or result in other costs to us which could adversely affect our operations and financial results.
Moreover, we are subject to examinations by the U.S. Internal Revenue Service and other domestic and foreign taxing authorities. Although we believe our worldwide provision for income taxes and other tax liabilities are reasonable, the determination of certain positions requires significant judgement, of which we cannot provide assurance that the final determination of any of these examinations will not have an adverse effect on our operating results and financial position.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
This data should be read in conjunction with our condensed consolidated statements of cash flows.
| As of | |||||||||||
| (in millions) | September 2, 2022 | December 3, 2021 | |||||||||
| Cash and cash equivalents | $ | 3,870 | $ | 3,844 | |||||||
| Short-term investments | $ | 1,894 | $ | 1,954 | |||||||
| Working capital | $ | 1,051 | $ | 1,737 | |||||||
| Stockholders’ equity | $ | 14,373 | $ | 14,797 |
A summary of our cash flows is as follows:
| Nine Months Ended | |||||||||||
| (in millions) | September 2, 2022 | September 3, 2021 | |||||||||
| Net cash provided by operating activities | $ | 5,513 | $ | 5,164 | |||||||
| Net cash used for investing activities | (501) | (1,798) | |||||||||
| Net cash used for financing activities | (4,914) | (3,223) | |||||||||
| Effect of foreign currency exchange rates on cash and cash equivalents | (72) | 2 | |||||||||
| Net change in cash and cash equivalents | $ | 26 | $ | 145 |
Our primary source of cash is receipts from revenue. Our primary uses of cash are our stock repurchase program as described below, payroll-related expenses, general operating expenses including marketing, travel and office rent, and cost of revenue. Other sources of cash include proceeds from participation in the employee stock purchase plan. Other uses of cash include business acquisitions, purchases of property and equipment and payments for taxes related to net share settlement of equity awards.
Cash Flows from Operating Activities
Net cash provided by operating activities of $5.51 billion for the nine months ended September 2, 2022 was primarily comprised of net income adjusted for the net effect of non-cash items and changes in operating assets and liabilities. The primary working capital sources of cash were net income, together with decreases in trade receivables driven by strong collections. The primary working capital uses of cash were decreases in accrued expenses and other liabilities largely driven by the payment of accrued bonuses and operating leases.
Cash Flows from Investing Activities
Net cash used for investing activities of $501 million for the nine months ended September 2, 2022 was primarily due to ongoing capital expenditures and business acquisitions.
Cash Flows from Financing Activities
Net cash used for financing activities of $4.91 billion for the nine months ended September 2, 2022 was primarily due to payments for our common stock repurchases and taxes paid related to the net share settlement of equity awards, offset in part by proceeds from re-issuance of treasury stock mainly for our employee stock purchase plan. See the section titled “Stock Repurchase Program” below.
Liquidity and Capital Resources Considerations
Our existing cash, cash equivalents and investment balances may fluctuate during fiscal 2022 due to changes in our planned cash outlay.
Cash from operations could also be affected by various risks and uncertainties, including, but not limited to, risks detailed in Part II, Item 1A titled “Risk Factors.” Based on our current business plan and revenue prospects, we believe that our existing cash, cash equivalents and investment balances, our anticipated cash flows from operations and our available credit facility will be sufficient to meet our working capital, operating resource expenditure and capital expenditure requirements for the next twelve months.
Our cash equivalent and short-term investment portfolio as of September 2, 2022 consisted of asset-backed securities, corporate debt securities, foreign government securities, money market funds, municipal securities, time deposits, U.S. agency securities and U.S. Treasury securities. We use professional investment management firms to manage a large portion of our invested cash.
We expect to continue our investing activities, including short-term and long-term investments, purchases of computer systems for research and development, sales and marketing, product support and administrative staff, and facilities expansion. Furthermore, cash reserves may be used to repurchase stock under our stock repurchase program and to strategically acquire companies, products or technologies that are complementary to our business.
Subsequent to September 2, 2022, we entered into a definitive agreement under which we intend to acquire Figma, Inc. (“Figma”) for approximately $20 billion, comprised of approximately half cash and half stock, subject to customary purchase price adjustments. Approximately 6 million additional restricted stock units will be granted to Figma’s Chief Executive Officer and employees that will vest over four years subsequent to closing. The transaction is subject to regulatory approvals and customary closing conditions, and is expected to close in 2023. We will be required to pay Figma a reverse termination fee of $1 billion if the transaction fails to receive regulatory clearance, assuming all other closing conditions have been satisfied or waived, or if it fails to close within 18 months from September 15, 2022. We expect to finance the cash portion of the consideration using cash, cash equivalent and short-term investment balances on hand and, if necessary, a term loan. While the transaction is pending, at a minimum we expect to maintain share repurchases sufficient to offset the dilution of equity issuances to our employees. See Note 3 of our notes to condensed consolidated financial statements for further information regarding our intended acquisition of Figma.
Revolving Credit Agreement
On June 30, 2022, we entered into a credit agreement (the “Revolving Credit Agreement”) with a syndicate of lenders, providing for a five-year $1.5 billion senior unsecured revolving credit facility through June 30, 2027, which replaces our previous five-year $1 billion senior unsecured revolving credit agreement dated as of October 17, 2018. Subject to the agreement of lenders, we may obtain up to an additional $500 million in commitments, for a maximum aggregate commitment of $2 billion. As of September 2, 2022, there were no outstanding borrowings under the Revolving Credit Agreement and the entire $1.5 billion credit line remains available for borrowing.
Under the terms of our Revolving Credit Agreement, we are not prohibited from paying cash dividends unless payment would trigger an event of default or if one currently exists. We do not anticipate paying any cash dividends in the foreseeable future.
Senior Notes
We have $4.15 billion senior notes outstanding, which rank equally with our other unsecured and unsubordinated indebtedness. As of September 2, 2022, the carrying value of our senior notes was $4.13 billion and our maximum commitment for interest payments was $416 million for the remaining duration of our outstanding senior notes. Interest is payable semi-annually, in arrears, on February 1 and August 1. Our senior notes do not contain any financial covenants. See Note 14 of our notes to condensed consolidated financial statements for further details regarding our debt.
During the first quarter of fiscal 2022, we reclassified the senior notes due February 1, 2023 as current debt in our condensed consolidated balance sheets. As of September 2, 2022, the carrying value of our current debt was $500 million, net of the related discount and issuance costs. We intend to refinance the current portion of our debt on or before the due date.
Contractual Obligations
Our principal commitments as of September 2, 2022 consisted of purchase obligations resulting from agreements to purchase goods and services in the ordinary course of business and obligations under operating lease arrangements. During the second quarter of fiscal 2022, we restructured certain of our long-term supplier commitments that increased our minimum purchase obligations by $4.75 billion through May 2029. There have been no other material changes to our non-cancellable unconditional purchase obligations during the nine months ended September 2, 2022.
Other
Our transition tax liability related to historical undistributed foreign earnings, which was accrued as a result of the U.S. Tax Act was approximately $313 million as of September 2, 2022 and is payable in installments through fiscal 2026. As we repatriate foreign earnings for use in the United States, the distributions will generally be exempt from federal income taxes under current U.S. tax law. In addition, the U.S. Tax Act requires companies to capitalize and amortize research and development expenditures starting fiscal 2023. If not modified, we anticipate an adverse impact to our effective rates for income taxes paid, which will be partially offset by the increase in the foreign-derived intangible income deduction, for fiscal 2023 and beyond.
The Inflation Reduction Act enacted on August 16, 2022 introduced new provisions including a corporate book minimum tax effective for us beginning in fiscal 2024 and an excise tax on net stock repurchases made after December 31, 2022. We are currently evaluating the impacts, if any, of these provisions to our results of operations and cash flows.
Stock Repurchase Program
To facilitate our stock repurchase program, designed to return value to our stockholders and minimize dilution from stock issuances, we may repurchase shares in the open market or enter into structured repurchase agreements with third parties. In December 2020, our Board of Directors granted authority to repurchase up to $15 billion in common stock through the end of fiscal 2024.
During the nine months ended September 2, 2022, we repurchased a total of 10.7 million shares, including approximately 5.4 million shares at an average price of $429.13 through structured repurchase agreements entered into during fiscal 2021 and the nine months ended September 2, 2022, as well as 5.3 million shares at an average purchase price of $451.55 through an accelerated share repurchase agreement entered into during the first quarter of fiscal 2022.
During the third quarter of fiscal 2022, we entered into a structured stock repurchase agreement with a large financial institution, whereupon we provided them with a prepayment of $1.2 billion. As of September 2, 2022, $400 million of prepayment remained under our outstanding structured stock repurchase agreement.
Subsequent to September 2, 2022, as part of the December 2020 stock repurchase authority, we entered into a structured stock repurchase agreement with a large financial institution whereupon we provided them with a prepayment of $1.75 billion. Upon completion of the $1.75 billion stock repurchase agreement, $6.55 billion remains under our December 2020 authority.
Indemnifications
In the ordinary course of business, we provide indemnifications of varying scope to customers and channel partners against claims of intellectual property infringement made by third parties arising from the use of our products and from time to time, we are subject to claims by our customers under these indemnification provisions. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.
To the extent permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that reduces our exposure and enables us to recover a portion of any future amounts paid.
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