filings.toolsItem 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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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 and revenue growth. 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 2022, 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 2023, we experienced strong demand across our Digital Media and Digital Experience offerings, driven by our innovative product roadmap. As we execute on our long-term growth initiatives and deliver product innovation, 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. 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. Subsequent to September 1, 2023, we also released Adobe Firefly, a group of creative generative AI models designed to generate high quality images and text effects. 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’ devices, 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, and delivering new features and technologies to existing customers with our latest releases such as share for review and generative AI capabilities. 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 existing users, continue to attract 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 and enhanced desktop, web 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, collaborate, 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, and is also included in our Creative Cloud all apps subscription offering.
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, which continue to contribute strong product-led 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 for measurement purposes. 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 |
Creative ARR exiting the third quarter of fiscal 2023 was $11.97 billion, up from $10.98 billion at the end of fiscal 2022. Document Cloud ARR exiting the third quarter of fiscal 2023 was $2.63 billion, up from $2.28 billion at the end of fiscal 2022. Total Digital Media ARR grew to $14.60 billion at the end of the third quarter of fiscal 2023, up from $13.26 billion at the end of fiscal 2022.
Our success in driving growth in ARR has positively affected our revenue growth. Creative revenue in the third quarter of fiscal 2023 was $2.91 billion, up from $2.63 billion in the third quarter of fiscal 2022, representing 11% year-over-year growth. Document Cloud revenue in the third quarter of fiscal 2023 was $685 million, up from $607 million in the third quarter of fiscal 2022, representing 13% year-over-year growth. Total Digital Media segment revenue grew to $3.59 billion in the third quarter of fiscal 2023, up from $3.23 billion in the third quarter of fiscal 2022, representing 11% 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 personalized experiences at scale 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 activation. 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 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 B2B and B2C use cases, including through Marketo Engage, Adobe Campaign, Adobe Target and Journey Optimizer.
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Marketing planning and 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 integrate 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 and our experience-led growth strategy.
Digital Experience revenue was $1.23 billion in the third quarter of fiscal 2023, up from $1.12 billion in the third quarter of fiscal 2022, representing 10% year-over-year growth. Driving this increase was the increase in subscription revenue, which grew to $1.10 billion in the third quarter of fiscal 2023 from $981 million in the third quarter of fiscal 2022, representing 12% year-over-year growth.
Macroeconomic Conditions
As a corporation with an extensive global footprint, we are subject to risks and exposures from the evolving macroeconomic environment, including the effects of increased global inflationary pressures and interest rates, fluctuations in foreign currency exchange rates, potential economic slowdowns or recessions and geopolitical pressures, including the unknown impacts of current and future trade regulations and the Russia-Ukraine war. We continuously monitor the direct and indirect impacts of these circumstances on our business and financial results. For example, foreign currency exchange rate fluctuations have negatively impacted our revenue and earnings during the nine months ended September 1, 2023 as compared to the nine months ended September 2, 2022, and may continue to negatively impact our financial results for the remainder of fiscal 2023.
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 1, 2023, 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 2, 2022.
Recent Accounting Pronouncements
RESULTS OF OPERATIONS
Financial Performance Summary
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Total Digital Media ARR of approximately $14.60 billion as of September 1, 2023 increased by $1.34 billion, or 10%, from $13.26 billion as of December 2, 2022. The change in our Digital Media ARR is primarily due to new user adoption of our Creative Cloud and Document Cloud offerings.
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Creative revenue during the three months ended September 1, 2023 of $2.91 billion increased by $284 million, or 11%, compared to the year-ago period. Document Cloud revenue during the three months ended September 1, 2023 of $685 million increased by $78 million, or 13%, 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 $1.23 billion during the three months ended September 1, 2023 increased by $109 million, or 10%, 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 $15.72 billion as of September 1, 2023 increased by $526 million, or 3%, from $15.19 billion as of December 2, 2022 primarily due to new contracts and renewals for our Digital Media and Digital Experience offerings.
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Cost of revenue of $580 million during the three months ended September 1, 2023 increased by $34 million, or 6%, compared to the year-ago period primarily due to increases in hosting services and data center costs.
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Operating expenses of $2.61 billion during the three months ended September 1, 2023 increased by $210 million, or 9%, compared to the year-ago period primarily due to increases in base and incentive compensation and related benefits costs, as well as professional fees including costs associated with our planned acquisition of Figma.
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Cash flows from operations of $5.71 billion during the nine months ended September 1, 2023 increased by $192 million, or 3%, compared to the year-ago period.
Revenue for the Three and Nine Months Ended September 1, 2023 and September 2, 2022
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Subscription | $ | 4,631 | $ | 4,128 | 12 | % | $ | 13,521 | $ | 12,156 | 11 | % | |||||||||||||||||||||||
| Percentage of total revenue | 95 | % | 93 | % | 94 | % | 93 | % | |||||||||||||||||||||||||||
| Product | 96 | 126 | (24) | % | 346 | 417 | (17) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 2 | % | 3 | % | 2 | % | 3 | % | |||||||||||||||||||||||||||
| Services and other | 163 | 179 | (9) | % | 494 | 508 | (3) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 3 | % | 4 | % | 4 | % | 4 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,890 | $ | 4,433 | 10 | % | $ | 14,361 | $ | 13,081 | 10 | % |
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 1, 2023 and September 2, 2022 is as follows:
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Digital Media | $ | 3,506 | $ | 3,116 | 13 | % | $ | 10,225 | $ | 9,190 | 11 | % | |||||||||||||||||||||||
| Digital Experience | 1,096 | 981 | 12 | % | 3,208 | 2,874 | 12 | % | |||||||||||||||||||||||||||
| Publishing and Advertising | 29 | 31 | (6) | % | 88 | 92 | (4) | % | |||||||||||||||||||||||||||
| Total subscription revenue | $ | 4,631 | $ | 4,128 | 12 | % | $ | 13,521 | $ | 12,156 | 11 | % |
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 or 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 | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Digital Media | $ | 3,594 | $ | 3,232 | 11 | % | $ | 10,500 | $ | 9,542 | 10 | % | |||||||||||||||||||||||
| Percentage of total revenue | 74 | % | 73 | % | 73 | % | 73 | % | |||||||||||||||||||||||||||
| Digital Experience | 1,229 | 1,120 | 10 | % | 3,627 | 3,272 | 11 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 25 | % | 25 | % | 25 | % | 25 | % | |||||||||||||||||||||||||||
| Publishing and Advertising | 67 | 81 | (17) | % | 234 | 267 | (12) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 1 | % | 2 | % | 2 | % | 2 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,890 | $ | 4,433 | 10 | % | $ | 14,361 | $ | 13,081 | 10 | % |
Digital Media
Revenue by major offerings in our Digital Media reportable segment for the three and nine months ended September 1, 2023 and September 2, 2022 were as follows:
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Creative Cloud | $ | 2,909 | $ | 2,625 | 11 | % | $ | 8,522 | $ | 7,778 | 10 | % | |||||||||||||||||||||||
| Document Cloud | 685 | 607 | 13 | % | 1,978 | 1,764 | 12 | % | |||||||||||||||||||||||||||
| Total Digital Media revenue | $ | 3,594 | $ | 3,232 | 11 | % | $ | 10,500 | $ | 9,542 | 10 | % |
Revenue from Digital Media increased $362 million and $958 million during the three and nine months ended September 1, 2023 as compared to the three and nine months ended September 2, 2022 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 engagement across customer segments, partially offset by the impact of foreign currency exchange rate fluctuations.
Digital Experience
Revenue from Digital Experience increased $109 million and $355 million during the three and nine months ended September 1, 2023 as compared to the three and nine months ended September 2, 2022 primarily due to net new additions across our subscription offerings, partially offset by the impact of foreign currency exchange rate fluctuations.
Geographical Information
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Americas | $ | 2,943 | $ | 2,600 | 13 | % | $ | 8,601 | $ | 7,570 | 14 | % | |||||||||||||||||||||||
| Percentage of total revenue | 60 | % | 59 | % | 60 | % | 58 | % | |||||||||||||||||||||||||||
| EMEA | 1,229 | 1,143 | 8 | % | 3,615 | 3,436 | 5 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 25 | % | 26 | % | 25 | % | 26 | % | |||||||||||||||||||||||||||
| APAC | 718 | 690 | 4 | % | 2,145 | 2,075 | 3 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 15 | % | 15 | % | 15 | % | 16 | % | |||||||||||||||||||||||||||
| Total revenue | $ | 4,890 | $ | 4,433 | 10 | % | $ | 14,361 | $ | 13,081 | 10 | % |
Overall revenue during the three and nine months ended September 1, 2023 increased in all geographic regions as compared to the three and nine months ended September 2, 2022. 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 1, 2023 as compared to the three and nine months ended September 2, 2022 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 1, 2023 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 $62 million and $367 million, respectively. For the three and nine months ended September 1, 2023, the foreign currency impacts to revenue were offset in part by net hedging gains from our cash flow hedging program of $5 million and $36 million, respectively.
Cost of Revenue for the Three and Nine Months Ended September 1, 2023 and September 2, 2022
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Subscription | $ | 447 | $ | 413 | 8 | % | $ | 1,317 | $ | 1,216 | 8 | % | |||||||||||||||||||||||
| Percentage of total revenue | 9 | % | 9 | % | 9 | % | 9 | % | |||||||||||||||||||||||||||
| Product | 7 | 8 | (13) | % | 23 | 27 | (15) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | * | * | * | * | |||||||||||||||||||||||||||||||
| Services and other | 126 | 125 | 1 | % | 380 | 354 | 7 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 3 | % | 3 | % | 3 | % | 3 | % | |||||||||||||||||||||||||||
| Total cost of revenue | $ | 580 | $ | 546 | 6 | % | $ | 1,720 | $ | 1,597 | 8 | % |
(*) 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 1, 2023 as compared to the three and nine months ended September 2, 2022 due to the following:
| Components of % Change 2023-2022 QTD | Components of % Change 2023-2022 YTD | ||||||||||
| Hosting services and data center costs | 8 | % | 7 | % | |||||||
| Royalty costs | 2 | 2 | |||||||||
| Amortization of intangibles | (2) | (1) | |||||||||
| Total change | 8 | % | 8 | % |
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 1, 2023 as compared to the three and nine months ended September 2, 2022 primarily due to increases in compensation costs partially offset by decreases in professional and consulting fees.
Operating Expenses for the Three and Nine Months Ended September 1, 2023 and September 2, 2022
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Research and development | $ | 881 | $ | 775 | 14 | % | $ | 2,584 | $ | 2,214 | 17 | % | |||||||||||||||||||||||
| Percentage of total revenue | 18 | % | 17 | % | 18 | % | 17 | % | |||||||||||||||||||||||||||
| Sales and marketing | 1,337 | 1,266 | 6 | % | 3,983 | 3,671 | 8 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 27 | % | 29 | % | 28 | % | 28 | % | |||||||||||||||||||||||||||
| General and administrative | 353 | 319 | 11 | % | 1,041 | 879 | 18 | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 7 | % | 7 | % | 7 | % | 7 | % | |||||||||||||||||||||||||||
| Amortization of intangibles | 42 | 43 | (2) | % | 126 | 127 | (1) | % | |||||||||||||||||||||||||||
| Percentage of total revenue | 1 | % | 1 | % | 1 | % | 1 | % | |||||||||||||||||||||||||||
| Total operating expenses | $ | 2,613 | $ | 2,403 | 9 | % | $ | 7,734 | $ | 6,891 | 12 | % |
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 1, 2023 as compared to the three and nine months ended September 2, 2022 due to the following:
| Components of % Change 2023-2022 QTD | Components of % Change 2023-2022 YTD | ||||||||||
| Base compensation and related benefits | 6 | % | 6 | % | |||||||
| Incentive compensation, cash and stock-based | 4 | 7 | |||||||||
| Hosting services and data center costs | 2 | 1 | |||||||||
| Various individually insignificant items | 2 | 3 | |||||||||
| Total change | 14 | % | 17 | % |
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 1, 2023 as compared to the three and nine months ended September 2, 2022 due to the following:
| Components of % Change 2023-2022 QTD | Components of % Change 2023-2022 YTD | ||||||||||
| Base compensation and related benefits | 3 | % | 4 | % | |||||||
| Incentive compensation, cash and stock-based | 2 | 3 | |||||||||
| Professional and consulting fees | 1 | 1 | |||||||||
| Marketing spend related to campaigns, events and overall marketing efforts | (2) | (2) | |||||||||
| Various individually insignificant items | 2 | 2 | |||||||||
| Total change | 6 | % | 8 | % |
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 1, 2023 as compared to the three and nine months ended September 2, 2022 due to the following:
| Components of % Change 2023-2022 QTD | Components of % Change 2023-2022 YTD | ||||||||||
| Professional and consulting fees | 8 | % | 10 | % | |||||||
| Base compensation and related benefits | 4 | 5 | |||||||||
| Incentive compensation, cash and stock-based | 2 | 3 | |||||||||
| Charitable contributions | (4) | (1) | |||||||||
| Various individually insignificant items | 1 | 1 | |||||||||
| Total change | 11 | % | 18 | % |
Professional and consulting fees increased during the three and nine months ended September 1, 2023 as compared to the three and nine months ended September 2, 2022 primarily due to transaction costs associated with our planned acquisition of Figma.
Non-Operating Income (Expense), Net for the Three and Nine Months Ended September 1, 2023 and September 2, 2022
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Interest expense | $ | (27) | $ | (28) | (4) | % | $ | (85) | $ | (84) | 1 | % | |||||||||||||||||||||||
| Percentage of total revenue | (1) | % | (1) | % | (1) | % | (1) | % | |||||||||||||||||||||||||||
| Investment gains (losses), net | 6 | (6) | ** | 12 | (23) | ** | |||||||||||||||||||||||||||||
| Percentage of total revenue | * | * | * | * | |||||||||||||||||||||||||||||||
| Other income (expense), net | 67 | 6 | ** | 157 | 5 | ** | |||||||||||||||||||||||||||||
| Percentage of total revenue | 1 | % | * | 1 | % | * | |||||||||||||||||||||||||||||
| Total non-operating income (expense), net | $ | 46 | $ | (28) | ** | $ | 84 | $ | (102) | ** |
(*) 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.
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.
Other income (expense), net increased during the three and nine months ended September 1, 2023 as compared to the three and nine months ended September 2, 2022 primarily due to increases in interest income driven by higher average interest rates.
Provision for Income Taxes for the Three and Nine Months Ended September 1, 2023 and September 2, 2022
| (dollars in millions) | Three Months | Nine Months | |||||||||||||||||||||||||||||||||
| 2023 | 2022 | % Change | 2023 | 2022 | % Change | ||||||||||||||||||||||||||||||
| Provision for income taxes | $ | 340 | $ | 320 | 6 | % | $ | 1,046 | $ | 911 | 15 | % | |||||||||||||||||||||||
| Percentage of total revenue | 7 | % | 7 | % | 7 | % | 7 | % | |||||||||||||||||||||||||||
| Effective tax rate | 20 | % | 22 | % | 21 | % | 20 | % |
Our effective tax rate decreased by approximately two percentage points for the three months ended September 1, 2023, as compared to the three months ended September 2, 2022, primarily due to an increase in the net tax benefit from effects of non-U.S. operations during the three months ended September 1, 2023. Our effective tax rate increased by approximately one percentage point for the nine months ended September 1, 2023, as compared to the nine months ended September 2, 2022, primarily due to a net tax expense related to stock-based compensation recorded during the nine months ended September 1, 2023, as compared to a net tax benefit related to stock-based compensation recorded during the year-ago period, partially offset by an increase in the net tax benefit from effects of non-U.S. operations during the nine months ended September 1, 2023.
Our effective tax rate for the three months ended September 1, 2023 was lower than the U.S. federal statutory tax rate of 21% primarily due to the net tax benefits from effects of non-U.S. operations and the U.S. federal research tax credit, partially offset by state taxes. Our effective tax rate for the nine months ended September 1, 2023 was the same as the U.S. federal statutory tax rate of 21% as the net tax benefits from effects of non-U.S. operations and the U.S. federal research tax credit were largely 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 based on evaluation of all available positive and negative evidence. 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 $398 million as of September 1, 2023, primarily related to certain state credits.
We are a United States-based multinational company subject to tax in multiple domestic 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 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.
Beginning in 2023, under the provisions introduced by the U.S. Tax Act, we are required to capitalize and amortize research and development costs. If the rule is not modified, there will continue to be an adverse impact on our effective rates for income taxes paid, which is partially offset by a benefit to our effective tax rates from the increase in the foreign-derived intangible income deduction, in fiscal 2023 and beyond.
Accounting for Uncertainty in Income Taxes
The gross liabilities for unrecognized tax benefits excluding interest and penalties were $436 million and $307 million as of September 1, 2023 and September 2, 2022, respectively. If the total unrecognized tax benefits as of September 1, 2023 and September 2, 2022 were recognized, $307 million and $198 million would decrease the respective effective tax rates.
As of September 1, 2023 and September 2, 2022, the combined amounts of accrued interest and penalties related to tax positions taken on our tax returns were approximately $27 million and $14 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. Although the timing of resolution, settlement and closing of audits is not certain, it is reasonably possible that the underlying unrecognized tax benefits may decrease by up to $30 million over the next 12 months.
Our future effective tax rates may be materially affected by changes in the tax rates in jurisdictions where our income is earned, changes in jurisdictions in which our profits are determined to be earned and taxed, changes in the valuation of our deferred tax assets and liabilities, changes in or interpretation of tax rules and regulations in the jurisdictions in which we do business, or unexpected changes in business and market conditions that could reduce certain tax benefits.
In addition, the United States and other countries and jurisdictions in which we conduct business, including those covered by governing bodies that enact tax laws applicable to us, such as the European Commission of the European Union, could make changes to relevant tax, accounting or other laws and interpretations thereof that have a material impact to us. These countries, 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 and, in some cases, have proposed or enacted new laws that are contrary to the way in which rules and regulations have historically been interpreted and applied. In the current global tax policy environment, any changes in laws, regulations and interpretations 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 the examination of our income tax returns by domestic and foreign tax authorities. We regularly assess the likelihood of outcomes resulting from these examinations to determine the adequacy of our provision for income taxes and have reserved for potential adjustments that may result from these examinations. Our policy is to record interest and penalties related to unrecognized tax benefits in income tax expense. We believe our tax estimates to be reasonable; however, we cannot provide assurance that the final determination of any of these examinations will not have an adverse effect on our financial position and results of operations.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows
Our primary source of cash is receipts from revenue. Our primary uses of cash are general business expenses including payroll, income taxes, marketing and third-party hosting services, as well as our stock repurchase program as described below. Other customary sources of cash include proceeds from maturities and sales of short-term investments. Other customary uses of cash include business acquisitions, repayment of maturing senior notes, purchases of property and equipment and payments for taxes related to net share settlement of equity awards.
This data should be read in conjunction with our condensed consolidated statements of cash flows.
| As of | |||||||||||
| (in millions) | September 1, 2023 | December 2, 2022 | |||||||||
| Cash and cash equivalents | $ | 6,601 | $ | 4,236 | |||||||
| Short-term investments | $ | 915 | $ | 1,860 | |||||||
| Working capital | $ | 2,076 | $ | 868 | |||||||
| Stockholders’ equity | $ | 15,776 | $ | 14,051 |
A summary of our cash flows is as follows:
| Nine Months Ended | |||||||||||
| (in millions) | September 1, 2023 | September 2, 2022 | |||||||||
| Net cash provided by operating activities | $ | 5,705 | $ | 5,513 | |||||||
| Net cash provided by (used for) investing activities | 623 | (501) | |||||||||
| Net cash used for financing activities | (3,965) | (4,914) | |||||||||
| Effect of foreign currency exchange rates on cash and cash equivalents | 2 | (72) | |||||||||
| Net change in cash and cash equivalents | $ | 2,365 | $ | 26 |
Cash Flows from Operating Activities
Net cash provided by operating activities of $5.71 billion for the nine months ended September 1, 2023 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 increases in income taxes payable due to the deferral of federal estimated tax payments to the fourth quarter of fiscal 2023 and decreases in trade receivables driven by strong collections, partially offset by increases in short term prepaid expenses.
Cash Flows from Investing Activities
Net cash provided by investing activities of $623 million for the nine months ended September 1, 2023 was primarily due to maturities and sales of short-term investments partially offset by ongoing capital expenditures.
Cash Flows from Financing Activities
Net cash used for financing activities of $3.97 billion for the nine months ended September 1, 2023 was primarily due to payments for our common stock repurchases, the repayment of our 2023 Notes and taxes paid related to the net share settlement of equity awards. The above uses of cash were offset in part by proceeds from re-issuance of treasury stock related to 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 2023 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 the section titled “Risk Factors” in titled Part II, Item 1A of this report. 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 revolving 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 1, 2023 consisted of asset-backed securities, corporate debt securities, money market funds, 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 and server hardware to operate our network infrastructure, 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.
On September 15, 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. We continue to work toward closing the transaction, subject to obtaining regulatory approvals and satisfying customary closing conditions. 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 on hand and debt instruments. 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.
Term Loan Credit Agreement
In January 2023, we entered into a delayed draw credit agreement, providing for a senior unsecured term loan (the “Term Loan”) of up to $3.5 billion for the purpose of partially funding the purchase price and related fees for our acquisition of Figma. The Term Loan is available for funding in a single drawing upon the closing of the Figma acquisition at any time prior to March 15, 2024 and will mature two years following the initial funding date. As of September 1, 2023, there were no outstanding borrowings under the Term Loan.
Revolving Credit Agreement
We have a $1.5 billion senior unsecured revolving credit agreement (the “Revolving Credit Agreement”) with a syndicate of lenders, providing for loans to us and certain of our subsidiaries through June 30, 2027. 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 1, 2023, 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 $3.65 billion senior notes outstanding, which rank equally with our other unsecured and unsubordinated indebtedness. As of September 1, 2023, the carrying value of our senior notes was $3.63 billion and our maximum commitment for interest payments was $321 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.
Commercial Paper Program
Subsequent to September 1, 2023, we established a commercial paper program under which we may issue unsecured commercial paper up to a total of $3 billion outstanding at any time, with maturities of up to 397 days from the date of issue. The net proceeds from the issuance of commercial paper are expected to be used for general corporate purposes, which may include working capital, capital expenditures, acquisitions, stock repurchases, refinancing indebtedness or any other general corporate purposes.
Contractual Obligations
Our principal commitments as of September 1, 2023 consisted of purchase obligations resulting from agreements to purchase goods and services in the ordinary course of business and obligations under operating lease arrangements. There have been no material changes in those obligations during the nine months ended September 1, 2023.
Other
Beginning in 2023, under the provisions introduced by the U.S. Tax Act, we are required to capitalize and amortize research and development costs. If the rule is not modified, there will continue to be an adverse impact on our effective rates for income taxes paid, which is partially offset by a benefit from the increase in the foreign-derived intangible income deduction, in fiscal 2023 and beyond.
The recent U.S. Internal Revenue Service disaster-area tax relief allows for deferral of our federal estimated tax payments to the fourth quarter of fiscal 2023. As of the third quarter of fiscal 2023, we have deferred approximately $830 million of fiscal 2023 federal estimated tax payments.
The Inflation Reduction Act enacted in 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 continue to monitor developments and evaluate impacts, if any, of these provisions on 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 our 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 our common stock through the end of fiscal 2024.
During the nine months ended September 1, 2023, we repurchased a total of 9.7 million shares, including approximately 5.7 million shares at an average price of $396.43 through structured repurchase agreements entered into during fiscal 2022 and the nine months ended September 1, 2023, as well as 4.0 million shares at an average purchase price of $348.46 through an accelerated share repurchase agreement entered into during the first quarter of fiscal 2023.
During the third quarter of fiscal 2023, we entered into a structured stock repurchase agreement with a large financial institution, whereupon we provided them with a prepayment of $1 billion. As of September 1, 2023, $333 million of the prepayment remained under our outstanding structured stock repurchase agreement.
Subsequent to September 1, 2023, 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 billion. Upon completion of the $1 billion stock repurchase agreement, $2.15 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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