10-Q 1 adbe10qq316.htm 10-Q Document

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________
 
FORM 10-Q
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 2, 2016

 or
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                   to                   
 
Commission File Number: 0-15175
 
ADOBE SYSTEMS INCORPORATED
(Exact name of registrant as specified in its charter)
_________________________
Delaware
(State or other jurisdiction of
incorporation or organization)
77-0019522
(I.R.S. Employer
Identification No.)

345 Park Avenue, San Jose, California 95110-2704
(Address of principal executive offices and zip code)

(408) 536-6000
(Registrant’s telephone number, including area code)
 _________________________
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
(Do not check if a smaller
reporting company)
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o  No x
The number of shares outstanding of the registrant’s common stock as of September 23, 2016 was 497,227,020.
 



ADOBE SYSTEMS INCORPORATED
FORM 10-Q
 
TABLE OF CONTENTS
 
 
 
Page No.

PART I—FINANCIAL INFORMATION
 
Item 1.

 

 

 

 

 

Item 2.

Item 3.

Item 4.
 
 
 
 

 PART II—OTHER INFORMATION
 
Item 1.

Item 1A.

Item 2.

Item 4.

Item 5.
Item 6.






 

2


PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except par value)
 
September 2,
2016
 
November 27,
2015
 
(Unaudited)
 
(*)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
767,672

 
$
876,560

Short-term investments
3,678,726

 
3,111,524

Trade receivables, net of allowances for doubtful accounts of $6,066 and $7,293, respectively
731,166

 
672,006

Prepaid expenses and other current assets
241,146

 
161,802

Total current assets
5,418,710

 
4,821,892

Property and equipment, net
811,524

 
787,421

Goodwill
5,433,180

 
5,366,881

Purchased and other intangibles, net
454,230

 
510,007

Investment in lease receivable
80,439

 
80,439

Other assets
169,358

 
159,832

Total assets
$
12,367,441

 
$
11,726,472

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 

 
 

Trade payables
$
83,444

 
$
93,307

Accrued expenses
666,278

 
679,884

Income taxes payable
10,662

 
6,165

Deferred revenue
1,745,282

 
1,434,200

Total current liabilities
2,505,666

 
2,213,556

Long-term liabilities:
 

 
 

Debt
1,916,591

 
1,907,231

Deferred revenue
52,703

 
51,094

Income taxes payable
276,131

 
256,129

Deferred income taxes
238,459

 
208,209

Other liabilities
99,945

 
88,673

Total liabilities
5,089,495

 
4,724,892

Stockholders’ equity:
 

 
 

Preferred stock, $0.0001 par value; 2,000 shares authorized, none issued

 

Common stock, $0.0001 par value; 900,000 shares authorized; 600,834 shares issued; 
497,025 and 497,809 shares outstanding, respectively
61

 
61

Additional paid-in-capital
4,541,798

 
4,184,883

Retained earnings
7,714,904

 
7,253,431

Accumulated other comprehensive income (loss)
(134,111
)
 
(169,080
)
Treasury stock, at cost (103,809 and 103,025 shares, respectively), net of reissuances
(4,844,706
)
 
(4,267,715
)
Total stockholders’ equity
7,277,946

 
7,001,580

Total liabilities and stockholders’ equity
$
12,367,441

 
$
11,726,472

_________________________________________ 
(*)
The Condensed Consolidated Balance Sheet as of November 27, 2015 has been derived from the audited Consolidated Financial Statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

3


ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 2,
2016
 
August 28,
2015
 
September 2,
2016
 
August 28,
2015
Revenue:
 
 
 
 
 
 
 
Subscription
$
1,168,602

 
$
829,065

 
$
3,322,560

 
$
2,316,470

Product
180,960

 
275,338

 
578,572

 
840,650

Services and support
114,405

 
113,365

 
344,879

 
331,987

Total revenue
1,463,967

 
1,217,768

 
4,246,011

 
3,489,107

 
Cost of revenue:
 

 
 
 
 

 
 
Subscription
116,990

 
103,605

 
339,664

 
302,826

Product
15,435

 
24,545

 
51,490

 
65,715

Services and support
70,276

 
62,835

 
212,198

 
174,415

Total cost of revenue
202,701

 
190,985

 
603,352

 
542,956

Gross profit
1,261,266

 
1,026,783

 
3,642,659

 
2,946,151

 
Operating expenses:
 

 
 
 
 

 
 
Research and development
248,450

 
218,660

 
718,138

 
642,216

Sales and marketing
477,475

 
422,031

 
1,415,155

 
1,241,770

General and administrative
143,702

 
122,578

 
429,233

 
397,867

Restructuring and other charges
(338
)
 
(751
)
 
(1,223
)
 
1,038

Amortization of purchased intangibles
22,652

 
18,246

 
60,034

 
50,599

Total operating expenses
891,941

 
780,764

 
2,621,337

 
2,333,490

 Operating income
369,325

 
246,019

 
1,021,322

 
612,661

 
Non-operating income (expense):
 

 
 
 
 

 
 
Interest and other income (expense), net
2,725

 
4,433

 
12,995

 
11,510

Interest expense
(17,281
)
 
(16,519
)
 
(52,924
)
 
(47,669
)
Investment gains (losses), net
1,532

 
(1,314
)
 
(2,955
)
 
339

Total non-operating income (expense), net
(13,024
)
 
(13,400
)
 
(42,884
)
 
(35,820
)
Income before income taxes
356,301

 
232,619

 
978,438

 
576,841

Provision for income taxes
85,513

 
58,154

 
209,269

 
169,995

Net income
$
270,788

 
$
174,465

 
$
769,169

 
$
406,846

Basic net income per share
$
0.54

 
$
0.35

 
$
1.54

 
$
0.82

Shares used to compute basic net income per share
498,584

 
498,630

 
499,224

 
498,891

Diluted net income per share
$
0.54

 
$
0.34

 
$
1.52

 
$
0.80

Shares used to compute diluted net income per share
503,669

 
505,809

 
505,135

 
507,124

 
 
 
 
 
 
 
 




4


ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 2,
2016
 
August 28,
2015
 
September 2,
2016
 
August 28,
2015
 
Increase/(Decrease)
 
Increase/(Decrease)
Net income
$
270,788

 
$
174,465

 
$
769,169

 
$
406,846

Other comprehensive income (loss), net of taxes:
 
 
 
 
 
 
 
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains / losses on available-for-sale securities
3,055

 
(8,334
)
 
21,677

 
(8,275
)
Reclassification adjustment for recognized gains / losses on available-for-sale securities
(869
)
 
(570
)
 
(1,982
)
 
(2,130
)
Net increase (decrease) from available-for-sale securities
2,186

 
(8,904
)
 
19,695

 
(10,405
)
Derivatives designated as hedging instruments:
 
 
 
 
 
 
 
Unrealized gains / losses on derivative instruments
13,233

 
(1,874
)
 
9,089

 
18,480

Reclassification adjustment for recognized gains / losses on derivative instruments
(3,656
)
 
(8,899
)
 
(9,964
)
 
(54,478
)
Net increase (decrease) from derivatives designated as hedging instruments
9,577

 
(10,773
)
 
(875
)
 
(35,998
)
Foreign currency translation adjustments
(12,828
)
 
8,318

 
16,149

 
(86,334
)
Other comprehensive income (loss), net of taxes
(1,065
)
 
(11,359
)
 
34,969

 
(132,737
)
Total comprehensive income, net of taxes
$
269,723

 
$
163,106

 
$
804,138

 
$
274,109






5


ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended
 
September 2,
2016
 
August 28,
2015
Cash flows from operating activities:
 
 
 
Net income
$
769,169

 
$
406,846

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 
Depreciation, amortization and accretion
249,675

 
253,114

Stock-based compensation
262,382

 
254,836

Deferred income taxes
44,164

 
(47,769
)
Unrealized losses (gains) on investments, net
3,916

 
(8,548
)
Tax benefit from stock-based compensation
69,266

 
58,326

Excess tax benefits from stock-based compensation
(69,269
)
 
(58,345
)
Other non-cash items
(124
)
 
260

Changes in operating assets and liabilities, net of acquired assets and assumed
      liabilities:
 
 
 
Trade receivables, net
(57,033
)
 
(104
)
Prepaid expenses and other current assets
(86,350
)
 
(24,453
)
Trade payables
(10,861
)
 
(614
)
Accrued expenses
(5,540
)
 
(43,405
)
Income taxes payable
26,657

 
83,307

Deferred revenue
308,075

 
141,536

Net cash provided by operating activities
1,504,127

 
1,014,987

Cash flows from investing activities:
 

 
 

Purchases of short-term investments
(1,813,509
)
 
(1,424,288
)
Maturities of short-term investments
557,769

 
254,020

Proceeds from sales of short-term investments
698,486

 
931,267

Acquisitions, net of cash acquired
(48,427
)
 
(826,004
)
Purchases of property and equipment
(155,172
)
 
(120,260
)
Purchases of long-term investments and other assets
(56,413
)
 
(20,853
)
Proceeds from sale of long-term investments
331

 
3,747

Net cash used for investing activities
(816,935
)
 
(1,202,371
)
Cash flows from financing activities:
 

 
 

Purchases of treasury stock
(775,000
)
 
(500,000
)
Proceeds from issuance of treasury stock
139,823

 
154,759

Cost of issuance of treasury stock
(224,243
)
 
(176,904
)
Excess tax benefits from stock-based compensation
69,269

 
58,345

Proceeds from debt issuance

 
989,280

Repayment of debt and capital lease obligations
(86
)
 
(602,189
)
Debt issuance costs

 
(8,828
)
Net cash used for financing activities
(790,237
)
 
(85,537
)
Effect of foreign currency exchange rates on cash and cash equivalents
(5,843
)
 
(15,187
)
Net decrease in cash and cash equivalents
(108,888
)
 
(288,108
)
Cash and cash equivalents at beginning of period
876,560

 
1,117,400

Cash and cash equivalents at end of period
$
767,672

 
$
829,292

Supplemental disclosures:
 

 
 
Cash paid for income taxes, net of refunds
$
108,508

 
$
61,546

Cash paid for interest
$
58,182

 
$
48,920

Non-cash investing activities:
 
 
 
Issuance of common stock and stock awards assumed in business acquisitions
$

 
$
677




6


ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 
(Unaudited)

NOTE 1.  BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
We have prepared the accompanying unaudited Condensed Consolidated Financial Statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Pursuant to these rules and regulations, we have condensed or omitted certain information and footnote disclosures we normally include in our annual Consolidated Financial Statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In management’s opinion, we have made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present our financial position, results of operations and cash flows. Our interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the Consolidated Financial Statements and notes thereto in our Annual Report on Form 10-K for the fiscal year ended November 27, 2015 on file with the SEC (our “Annual Report”).
Fiscal Year
Our fiscal year is a 52- or 53-week year that ends on the Friday closest to November 30. Our financial results for the nine months ended September 2, 2016 benefited from an extra week in the first quarter of fiscal 2016 due to our 52/53 week financial calendar whereby fiscal 2016 is a 53-week year compared with fiscal 2015 which was a 52-week year.
Reclassifications
Certain prior year amounts have been reclassified to conform to current year presentation in the Condensed Consolidated Balance Sheets and Condensed Consolidated Statements of Cash Flows.
Significant Accounting Policies
There have been no material changes to our significant accounting policies as compared to the significant accounting policies described in our Annual Report.
Recent Accounting Pronouncements Not Yet Effective
On May 28, 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either the retrospective or cumulative effect transition method. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which deferred the effective date of the new revenue standard for periods beginning after December 15, 2016 to December 15, 2017, with early adoption permitted but not earlier than the original effective date. Accordingly, the updated standard is effective for us in the first quarter of fiscal 2019. We have not yet selected a transition method and we are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.
On February 24, 2016, the FASB issued ASU No. 2016-02, Leases, requiring lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. For lessees, leases will continue to be classified as either operating or finance leases in the income statement. Lessor accounting is similar to the current model but updated to align with certain changes to the lessee model. Lessors will continue to classify leases as operating, direct financing or sales-type leases. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance at the beginning of the earliest comparative period presented. The updated standard is effective for us beginning in the first quarter of fiscal 2020. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

7


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

On March 30, 2016, the FASB issued ASU No. 2016-09, Improvements to Employee Share-Based Payment Accounting, which simplifies various aspects related to the accounting and presentation of share-based payments. The amendments require entities to record all tax effects related to share-based payments at settlement or expiration through the income statement and the windfall tax benefit to be recorded when it arises, subject to normal valuation allowance considerations. All tax-related cash flows resulting from share-based payments are required to be reported as operating activities in the statement of cash flows. The updates relating to the income tax effects of the share-based payments including the cash flow presentation must be adopted either prospectively or retrospectively. Further, the amendments allow the entities to make an accounting policy election to either estimate forfeitures or recognize forfeitures as they occur. If an election is made, the change to recognize forfeitures as they occur must be adopted using a modified retrospective approach with a cumulative effect adjustment recorded to opening retained earnings. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2016 and interim periods within those fiscal years. The updated standard is effective for us beginning in the first quarter of fiscal 2018. Early adoption is permitted. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.
With the exception of the new standards discussed above, there have been no other recent accounting pronouncements or changes in accounting pronouncements during the nine months ended September 2, 2016, as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K for the fiscal year ended November 27, 2015, that are of significance or potential significance to us.
NOTE 2.  ACQUISITIONS
On January 27, 2015, we completed our acquisition of privately held Fotolia, a leading marketplace for royalty-free photos, images, graphics and HD videos.
During the first quarter of fiscal 2015, we began integrating Fotolia into our Digital Media reportable segment. Under the acquisition method of accounting, the total final purchase price was allocated to Fotolia's net tangible and intangible assets based upon their estimated fair values as of January 27, 2015. The total final purchase price for Fotolia was $807.5 million of which $745.1 million was allocated to goodwill that was non-deductible for tax purposes, $204.4 million to identifiable intangible assets and $142.0 million to net liabilities assumed.
We completed an immaterial acquisition during the nine months ended September 2, 2016.
Pro forma information has not been presented for these acquisitions as the impact to our Condensed Consolidated Financial Statements was not material.

8


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 3.  CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash equivalents consist of instruments with remaining maturities of three months or less at the date of purchase. We classify all of our cash equivalents and short-term investments as “available-for-sale.” In general, these investments are free of trading restrictions. We carry these investments at fair value, based on quoted market prices or other readily available market information. Unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our Condensed Consolidated Balance Sheets. Gains and losses are recognized when realized in our Condensed Consolidated Statements of Income. When we have determined that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to a credit loss is recognized in income. Gains and losses are determined using the specific identification method.
Cash, cash equivalents and short-term investments consisted of the following as of September 2, 2016 (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Current assets:
 
 
 
 
 
 
 
Cash
$
182,417

 
$

 
$

 
$
182,417

Cash equivalents:
 
 
 
 
 
 
 
Corporate bonds and commercial paper
7,491

 

 
(3
)
 
7,488

Money market mutual funds
560,630

 

 

 
560,630

Time deposits
14,537

 

 

 
14,537

U.S. Treasury securities
2,600

 

 

 
2,600

Total cash equivalents
585,258

 

 
(3
)
 
585,255

Total cash and cash equivalents
767,675

 

 
(3
)
 
767,672

Short-term fixed income securities:
 
 
 
 
 
 
 
Asset-backed securities
107,976

 
259

 
(33
)
 
108,202

Corporate bonds and commercial paper
2,338,853

 
14,919

 
(810
)
 
2,352,962

Municipal securities
140,247

 
173

 
(63
)
 
140,357

U.S. agency securities
44,836

 
84

 
(1
)
 
44,919

U.S. Treasury securities
1,031,685

 
863

 
(262
)
 
1,032,286

Total short-term investments
3,663,597

 
16,298

 
(1,169
)
 
3,678,726

Total cash, cash equivalents and short-term investments
$
4,431,272

 
$
16,298

 
$
(1,172
)
 
$
4,446,398



9


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Cash, cash equivalents and short-term investments consisted of the following as of November 27, 2015 (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Current assets:
 
 
 
 
 
 
 
Cash
$
352,371

 
$

 
$

 
$
352,371

Cash equivalents:
 

 
 
 
 
 
 

Money market mutual funds
482,479

 

 

 
482,479

Municipal securities
1,850

 

 
(1
)
 
1,849

Time deposits
13,461

 

 

 
13,461

U.S. Treasury securities
26,400

 

 

 
26,400

Total cash equivalents
524,190

 

 
(1
)
 
524,189

Total cash and cash equivalents
876,561

 

 
(1
)
 
876,560

Short-term fixed income securities:
 
 
 
 
 
 
 

Asset-backed securities
83,449

 
11

 
(146
)
 
83,314

Corporate bonds and commercial paper
1,890,253

 
2,273

 
(5,612
)
 
1,886,914

Foreign government securities
1,276

 

 
(8
)
 
1,268

Municipal securities
137,280

 
101

 
(49
)
 
137,332

U.S. agency securities
130,397

 
85

 
(14
)
 
130,468

U.S. Treasury securities
873,400

 
101

 
(1,273
)
 
872,228

Total short-term investments
3,116,055

 
2,571

 
(7,102
)
 
3,111,524

Total cash, cash equivalents and short-term investments
$
3,992,616

 
$
2,571

 
$
(7,103
)
 
$
3,988,084


The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category, that have been in an unrealized loss position for less than twelve months, as of September 2, 2016 and November 27, 2015 (in thousands):
 
2016
 
2015
 
Fair 
Value
 
Gross
Unrealized
Losses
 
Fair 
Value
 
Gross
Unrealized
Losses
Corporate bonds and commercial paper
$
412,377

 
$
(694
)
 
$
1,112,883

 
$
(5,377
)
Asset-backed securities
29,605

 
(32
)
 
60,057

 
(147
)
Municipal securities
63,569

 
(63
)
 
35,594

 
(50
)
Foreign government securities

 

 
1,268

 
(8
)
U.S. Treasury and agency securities
327,554

 
(263
)
 
820,570

 
(1,287
)
Total
$
833,105

 
$
(1,052
)
 
$
2,030,372

 
$
(6,869
)
 
There were 435 securities and 914 securities in an unrealized loss position for less than twelve months at September 2, 2016 and at November 27, 2015, respectively.

10


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category, that were in a continuous unrealized loss position for more than twelve months, as of September 2, 2016 and November 27, 2015 (in thousands):
 
2016
 
2015
 
Fair 
Value
 
Gross
Unrealized
Losses
 
Fair 
Value
 
Gross
Unrealized
Losses
Corporate bonds and commercial paper
$
50,804

 
$
(119
)
 
$
30,218

 
$
(233
)
Asset-backed securities
771

 
(1
)
 

 

Municipal securities

 

 
1,300

 
(1
)
Total
$
51,575

 
$
(120
)
 
$
31,518

 
$
(234
)
There were 28 securities and 15 securities in an unrealized loss position for more than twelve months at September 2, 2016 and at November 27, 2015, respectively.
The following table summarizes the cost and estimated fair value of short-term fixed income securities classified as short-term investments based on stated effective maturities as of September 2, 2016 (in thousands):
 
Amortized
Cost
 
Estimated
Fair Value
Due within one year
$
1,180,113

 
$
1,180,709

Due between one and two years
1,269,013

 
1,272,120

Due between two and three years
784,265

 
789,137

Due after three years
430,206

 
436,760

Total
$
3,663,597

 
$
3,678,726

We review our debt and marketable equity securities classified as short-term investments on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. We consider factors such as the length of time and extent to which the market value has been less than the cost, the financial condition and near-term prospects of the issuer and our intent to sell, or whether it is more likely than not we will be required to sell the investment before recovery of the investment’s amortized cost basis. If we believe that an other-than-temporary decline exists in one of these securities, we write down these investments to fair value. For debt securities, the portion of the write-down related to credit loss would be recorded to interest and other income, net in our Condensed Consolidated Statements of Income. Any portion not related to credit loss would be recorded to accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our Condensed Consolidated Balance Sheets. For equity securities, the write-down would be recorded to investment gains (losses), net in our Condensed Consolidated Statements of Income. During the nine months ended September 2, 2016, we did not consider any of our investments to be other-than-temporarily impaired.

11


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 4.  FAIR VALUE MEASUREMENTS
Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis
We measure certain financial assets and liabilities at fair value on a recurring basis. There have been no transfers between fair value measurement levels during the nine months ended September 2, 2016.
The fair value of our financial assets and liabilities at September 2, 2016 was determined using the following inputs (in thousands):
 
Fair Value Measurements at Reporting Date Using
 
 
 
Quoted Prices
in Active
Markets for
Identical Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Corporate bonds and commercial paper
$
7,488

 
$

 
$
7,488

 
$

Money market mutual funds
560,630

 
560,630

 

 

Time deposits
14,537

 
14,537

 

 

U.S. Treasury securities
2,600

 

 
2,600

 

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
108,202

 

 
108,202

 

Corporate bonds and commercial paper
2,352,962

 

 
2,352,962

 

Municipal securities
140,357

 

 
140,357

 

U.S. agency securities
44,919

 

 
44,919

 

U.S. Treasury securities
1,032,286

 

 
1,032,286

 

Prepaid expenses and other current assets:
 
 
 

 
 

 
 

Foreign currency derivatives
19,278

 

 
19,278

 

Other assets:
 
 
 

 
 
 
 
Deferred compensation plan assets
41,690

 
1,214

 
40,476

 

Interest rate swap derivatives
28,024

 

 
28,024

 

Total assets
$
4,352,973

 
$
576,381

 
$
3,776,592

 
$

Liabilities:
 

 
 

 
 

 
 

Accrued expenses:
 

 
 

 
 

 
 

Foreign currency derivatives
$
1,696

 
$

 
$
1,696

 
$

Total liabilities
$
1,696

 
$

 
$
1,696

 
$



12


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The fair value of our financial assets and liabilities at November 27, 2015 was determined using the following inputs (in thousands): 
 
Fair Value Measurements at Reporting Date Using
 
 
 
Quoted Prices
in Active
Markets for
Identical Assets
 
Significant
Other
Observable
Inputs
 
Significant
Unobservable
Inputs
 
Total
 
(Level 1)
 
(Level 2)
 
(Level 3)
Assets:
 
 
 
 
 
 
 
Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
$
482,479

 
$
482,479

 
$

 
$

Municipal securities
1,849

 

 
1,849

 

Time deposits
13,461

 
13,461

 

 

U.S. Treasury securities
26,400

 

 
26,400

 

Short-term investments:
 

 
 
 
 
 
 
Asset-backed securities
83,314

 

 
83,314

 

Corporate bonds and commercial paper
1,886,914

 

 
1,886,914

 

Foreign government securities
1,268

 

 
1,268

 

Municipal securities
137,332

 

 
137,332

 

U.S. agency securities
130,468

 

 
130,468

 

U.S. Treasury securities 
872,228

 

 
872,228

 

Prepaid expenses and other current assets:
 

 
 

 
 

 
 

Foreign currency derivatives
19,126

 

 
19,126

 

Other assets:
 

 
 

 
 

 
 

Deferred compensation plan assets
32,063

 
971

 
31,092

 

Interest rate swap derivatives
19,821

 

 
19,821

 

Total assets
$
3,706,723

 
$
496,911

 
$
3,209,812

 
$

Liabilities:
 

 
 

 
 

 
 

Accrued expenses:
 

 
 

 
 

 
 

Foreign currency derivatives
$
2,154

 
$

 
$
2,154

 
$

Total liabilities
$
2,154

 
$

 
$
2,154

 
$


Our fixed income available-for-sale debt securities consist of high quality, investment grade securities from diverse issuers with a minimum credit rating of BBB- and a weighted average credit rating of AA-. We value these securities based on pricing from independent pricing vendors who use matrix pricing valuation techniques including market approach methodologies that model information generated by market transactions involving identical or comparable assets, as well as discounted cash flow methodologies. Inputs include quoted prices in active markets for identical assets or inputs other than quoted prices that are observable either directly or indirectly in determining fair value, including benchmark yields, issuer spreads off benchmark yields, interest rates and U.S. Treasury or swap curves. We therefore classify all of our fixed income available-for-sale securities as Level 2. We perform routine procedures such as comparing prices obtained from multiple independent sources to ensure that appropriate fair values are recorded.
The fair values of our money market mutual funds and time deposits are based on the closing price of these assets as of the reporting date. We classify our money market mutual funds and time deposits as Level 1.
Our Level 2 over-the-counter foreign currency and interest rate swap derivatives are valued using pricing models and discounted cash flow methodologies based on observable foreign exchange and interest rate data at the measurement date.

13


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

We also have direct investments in privately held companies accounted for under the cost method, which are periodically assessed for other-than-temporary impairment. If we determine that an other-than-temporary impairment has occurred, we write down the investment to its fair value. We estimate fair value of our cost method investments considering available information such as pricing in recent rounds of financing, current cash positions, earnings and cash flow forecasts, recent operational performance and any other readily available market data. For the three and nine months ended September 2, 2016, we determined there was an immaterial other-than-temporary impairment on certain of our cost method investments and wrote down the investments to fair value. For the three and nine months ended August 28, 2015, we determined there were no other-than-temporary impairments on our cost method investments.
As of September 2, 2016, the carrying value of our lease receivables approximated fair value, based on Level 2 valuation inputs which include Treasury rates, London Interbank Offered Rate (“LIBOR”) interest rates and applicable credit spreads. See Note 11 for further details regarding our investment in lease receivable.
The fair value of our senior notes was $2.05 billion as of September 2, 2016, based on observable market prices in less active markets and categorized as Level 2. See Note 12 for further details regarding our debt.
NOTE 5.  DERIVATIVES AND HEDGING ACTIVITIES
Hedge Accounting and Hedging Programs
We recognize all derivative instruments as either assets or liabilities on our Condensed Consolidated Balance Sheets and measure them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting.

We evaluate hedge effectiveness at the inception of the hedge prospectively as well as retrospectively, and record any ineffective portion of the hedging instruments in interest and other income (expense), net in our Condensed Consolidated Statements of Income. The time value of purchased contracts is recorded in interest and other income (expense), net in our Condensed Consolidated Statements of Income.

The bank counterparties to these contracts expose us to credit-related losses in the event of their nonperformance which are largely mitigated with collateral security agreements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. In addition, the Company enters into master netting arrangements which have the ability to further limit credit-related losses with the same counterparty by permitting net settlement of transactions. Our hedging policy also establishes maximum limits for each counterparty to mitigate any concentration of risk.
Balance Sheet Hedging—Hedges of Foreign Currency Assets and Liabilities
We hedge our net recognized foreign currency denominated assets and liabilities with foreign exchange forward contracts to reduce the risk that the value of these assets and liabilities will be adversely affected by changes in exchange rates. These contracts hedge assets and liabilities that are denominated in foreign currencies and are carried at fair value with changes in the fair value recorded to interest and other income (expense), net in our Condensed Consolidated Statements of Income. These contracts do not subject us to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the assets and liabilities being hedged.

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

In countries outside the United States, we transact business in U.S. Dollars and in various other currencies. We may use foreign exchange option contracts or forward contracts to hedge certain cash flow exposures resulting from changes in these

14


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

foreign currency exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge a portion of our forecasted foreign currency denominated revenue in the normal course of business and accordingly, they are not speculative in nature.
To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge, and the hedges must be highly effective in offsetting changes to future cash flows on hedged transactions. We record changes in the intrinsic value of these cash flow hedges in accumulated other comprehensive income (loss) on our Condensed Consolidated Balance Sheets, until the forecasted transaction occurs. When the forecasted transaction occurs, we reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income (loss) to interest and other income (expense), net in our Condensed Consolidated Statements of Income at that time. If we do not elect hedge accounting, or the contract does not qualify for hedge accounting treatment, the changes in fair value from period to period are recorded in interest and other income (expense), net in our Condensed Consolidated Statements of Income.
In December 2014, prior to issuing new long-term fixed rate debt, we entered into an interest rate lock agreement on a notional amount of $600 million to hedge against the variability of future interest payments due to changes in the benchmark interest rate. This instrument was designated as a cash flow hedge. Upon issuance of our $1 billion of 3.25% senior notes due February 1, 2025 (the “2025 Notes”) in January 2015, we terminated the instrument and incurred a loss of $16.2 million. This loss is recorded in the stockholders’ equity section on our Condensed Consolidated Balance Sheets in accumulated other comprehensive income (loss) and will be reclassified to interest expense over a ten-year term consistent with the impact of the hedged item. See Note 12 for further details regarding our debt.

Fair Value Hedging - Hedges of Interest Rate Risk

During the third quarter of fiscal 2014, we entered into interest rate swaps designated as fair value hedges related to our $900 million of 4.75% fixed interest rate senior notes due February 1, 2020 (the “2020 Notes”). In effect, the interest rate swaps convert the fixed interest rate on our 2020 Notes to a floating interest rate based on LIBOR. Under the terms of the swaps, we will pay monthly interest at the one-month LIBOR interest rate plus a fixed number of basis points on the $900 million notional amount through February 1, 2020. In exchange, we will receive 4.75% fixed rate interest from the swap counterparties. See Note 12 for further details regarding our debt.

The interest rate swaps are accounted for as fair value hedges and substantially offset the changes in fair value of the hedged portion of the underlying debt that are attributable to the changes in market risk. Therefore, the gains and losses related to changes in the fair value of the interest rate swaps are included in interest and other income (expense), net in our Condensed Consolidated Statement of Income. The fair value of the interest rate swaps is reflected as either an asset or liability on our Condensed Consolidated Balance Sheets.

The fair value of derivative instruments on our Condensed Consolidated Balance Sheets as of September 2, 2016 and November 27, 2015 were as follows (in thousands):
 
2016
 
2015
 
Fair Value
Asset
Derivatives
 
Fair Value
Liability
Derivatives
 
Fair Value
Asset
Derivatives
 
Fair Value
Liability
Derivatives
Derivatives designated as hedging instruments:
 
 
 
 
 
 
 
Foreign exchange option contracts(1) (3) 
$
16,444

 
$

 
$
16,979

 
$

Interest rate swap (2)
28,024

 

 
19,821

 

Derivatives not designated as hedging instruments:
 
 
 
 
 
 
 
 Foreign exchange forward contracts (1)
2,834

 
1,696

 
2,147

 
2,154

Total derivatives
$
47,302

 
$
1,696

 
$
38,947

 
$
2,154


15


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

_________________________________________ 
(1) 
Included in prepaid expenses and other current assets and accrued expenses for asset derivatives and liability derivatives, respectively, on our Condensed Consolidated Balance Sheets.
(2) 
Included in other assets or other liabilities on our Condensed Consolidated Balance Sheets.
(3) 
Hedging effectiveness expected to be recognized into income within the next twelve months.
 
The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our Condensed Consolidated Statements of Income for the three and nine months ended September 2, 2016 was as follows (in thousands):
 
Three Months
 
Nine Months
 
Foreign
Exchange
Option
Contracts
 
Foreign
Exchange
Forward
Contracts
 
Foreign
Exchange
Option
Contracts
 
Foreign
Exchange
Forward
Contracts
Derivatives in cash flow hedging relationships:
 
 
 
 
 
 
 
Net gain (loss) recognized in OCI, net of tax(1) 
$
13,233

 
$

 
$
9,089

 
$

Net gain (loss) reclassified from accumulated
OCI into income, net of tax(2)
$
3,904

 
$

 
$
10,732

 
$

Net gain (loss) recognized in income(3) 
$
(7,733
)
 
$

 
$
(19,242
)
 
$

Derivatives not designated as hedging relationships:
 
 
 
 
 
 
 
Net gain (loss) recognized in income(4) 
$

 
$
1,368

 
$

 
$
(1,335
)
The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our Condensed Consolidated Statements of Income for the three and nine months ended August 28, 2015 was as follows (in thousands):
 
Three Months
 
Nine Months
 
Foreign
Exchange
Option
Contracts
 
Foreign
Exchange
Forward
Contracts
 
Foreign
Exchange
Option
Contracts
 
Foreign
Exchange
Forward
Contracts
Derivatives in cash flow hedging relationships:
 
 
 
 
 
 
 
Net gain (loss) recognized in OCI, net of tax(1) 
$
(1,874
)
 
$

 
$
28,509

 
$

Net gain (loss) reclassified from accumulated
OCI into income, net of tax(2)
$
9,146

 
$

 
$
55,068

 
$

Net gain (loss) recognized in income(3) 
$
(3,933
)
 
$

 
$
(11,074
)
 
$

Derivatives not designated as hedging relationships:
 
 
 
 
 
 
 
Net gain (loss) recognized in income(4) 
$

 
$
628

 
$

 
$
4,703

_________________________________________ 
(1) 
Net change in the fair value of the effective portion classified in other comprehensive income (“OCI”).
(2) 
Effective portion classified as revenue.
(3) 
Ineffective portion and amount excluded from effectiveness testing classified in interest and other income (expense), net.
(4) 
Classified in interest and other income (expense), net.

16


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6.  GOODWILL AND PURCHASED AND OTHER INTANGIBLES
Goodwill as of September 2, 2016 and November 27, 2015 was $5.43 billion and $5.37 billion, respectively. The increase was due to foreign currency translation adjustments and an immaterial acquisition during the nine months ended September 2, 2016. During the second quarter of fiscal 2016, we completed our annual goodwill impairment test associated with our reporting units and determined there was no impairment of goodwill.
Purchased and other intangible assets subject to amortization as of September 2, 2016 and November 27, 2015 were as follows (in thousands): 
 
2016
 
2015
 
Cost
 
Accumulated Amortization
 
Net
 
Cost
 
Accumulated Amortization
 
Net
Purchased technology
$
175,719

 
$
(99,741
)
 
$
75,978

 
$
199,053

 
$
(104,704
)
 
$
94,349

Customer contracts and relationships
$
553,453

 
$
(265,945
)
 
$
287,508

 
$
506,639

 
$
(204,578
)
 
$
302,061

Trademarks
78,655

 
(46,616
)
 
32,039

 
81,219

 
(41,175
)
 
40,044

Acquired rights to use technology
93,310

 
(62,171
)
 
31,139

 
144,202

 
(100,278
)
 
43,924

Localization
2,122

 
(765
)
 
1,357

 
1,500

 
(358
)
 
1,142

Other intangibles
41,093

 
(14,884
)
 
26,209

 
36,280

 
(7,793
)
 
28,487

Total other intangible assets
$
768,633

 
$
(390,381
)
 
$
378,252

 
$
769,840

 
$
(354,182
)
 
$
415,658

Purchased and other intangible assets, net
$
944,352

 
$
(490,122
)
 
$
454,230

 
$
968,893

 
$
(458,886
)
 
$
510,007

 
In the third quarter of fiscal 2016, purchased intangibles associated with our acquisition of EchoSign and certain other acquired rights technology became fully amortized and were removed from the Condensed Consolidated Balance Sheets.
Amortization expense related to purchased and other intangible assets was $40.0 million and $115.4 million for the three and nine months ended September 2, 2016, respectively. Comparatively, amortization expense related to purchased and other intangible assets was $46.3 million and $131.6 million for the three and nine months ended August 28, 2015, respectively. Of these amounts $16.9 million and $54.4 million were included in cost of sales for the three and nine months ended September 2, 2016, respectively, and $27.7 million and $80.0 million for the three and nine months ended August 28, 2015, respectively.
As of September 2, 2016, we expect amortization expense in future periods to be as follows (in thousands):
Fiscal Year
 
Purchased
Technology
 
Other Intangible
Assets
Remainder of 2016
$
7,147

 
$
31,497

2017
24,364

 
103,554

2018
17,249

 
91,650

2019
11,312

 
64,753

2020
9,103

 
35,446

Thereafter
6,803

 
51,352

Total expected amortization expense
$
75,978

 
$
378,252


17


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7.  ACCRUED EXPENSES
Accrued expenses as of September 2, 2016 and November 27, 2015 consisted of the following (in thousands):
 
2016
 
2015
Accrued compensation and benefits
$
312,861

 
$
312,776

Sales and marketing allowances 
60,945

 
66,876

Accrued corporate marketing
51,929

 
38,512

Taxes payable
37,461

 
27,996

Royalties payable
20,313

 
23,334

Accrued interest expense
6,993

 
26,538

Other
175,776

 
183,852

Accrued expenses
$
666,278

 
$
679,884


Other primarily includes general corporate accruals including restructuring charges, and local and regional expenses. Other is also comprised of deferred rent related to office locations with rent escalations and foreign currency liability derivatives.
NOTE 8.  STOCK-BASED COMPENSATION
Summary of Restricted Stock Units
Restricted stock unit activity for the nine months ended September 2, 2016 and the fiscal year ended November 27, 2015 was as follows (in thousands):
 
2016
 
2015
Beginning outstanding balance
10,069

 
13,564

Awarded
4,087

 
4,012

Released
(5,152
)
 
(6,561
)
Forfeited
(606
)
 
(946
)
Ending outstanding balance
8,398

 
10,069

Information regarding restricted stock units outstanding at September 2, 2016 and August 28, 2015 is summarized below:
 
Number of
Shares
(thousands)
 
Weighted
Average
Remaining
Contractual
Life
(years)
 
Aggregate
Intrinsic
Value(*)
(millions)
2016
 
 
 
 
 
Restricted stock units outstanding
8,398

 
1.25
 
$
869.7

Restricted stock units vested and expected to vest
7,597

 
1.19
 
$
775.2

2015
 

 
 
 
 

Restricted stock units outstanding
10,288

 
1.10
 
$
816.9

Restricted stock units vested and expected to vest
9,320

 
1.03
 
$
730.3

_________________________________________ 
(*) 
The intrinsic value is calculated as the market value as of the end of the fiscal period. As reported by the NASDAQ Global Select Market, the market values as of September 2, 2016 and August 28, 2015 were $103.57 and $79.40, respectively. 

18


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Summary of Performance Shares 
Our 2016, 2015 and 2014 Performance Share Programs aim to help focus key employees on building stockholder value, provide significant award potential for achieving outstanding Company performance and enhance the ability of the Company to attract and retain highly talented and competent individuals. The Executive Compensation Committee of our Board of Directors approves the terms of each of our Performance Share Programs, including the award calculation methodology, under the terms of our 2003 Equity Incentive Plan. Shares may be earned based on the achievement of an objective relative total stockholder return measured over a three-year performance period. Performance share awards will be awarded and fully vest upon the Executive Compensation Committee's certification of the level of achievement following the three-year anniversary of each grant date. Program participants generally have the ability to receive up to 200% of the target number of shares originally granted.
In the first quarter of fiscal 2016, the Executive Compensation Committee approved the 2016 Performance Share Program, the terms of which are similar to prior year performance share programs as discussed above.

In the first quarter of fiscal 2016, the Executive Compensation Committee also certified the actual performance achievement of participants in the 2013 Performance Share Program. Actual performance resulted in participants achieving 198% of target or approximately 1.4 million shares. The shares granted and achieved under the 2013 Performance Share Program fully vested on the third-year anniversary of the grant on January 24, 2016, if not forfeited. As of September 2, 2016, the shares awarded under our 2016, 2015 and 2014 Performance Share Programs are yet to be achieved.

The following table sets forth the summary of performance share activity under our Performance Share Programs for the nine months ended September 2, 2016 and the fiscal year ended November 27, 2015 (in thousands): 
 
2016
 
2015
 
Shares
Granted
 
Maximum
Shares Eligible
to Receive
 
Shares
Granted
 
Maximum
Shares Eligible
to Receive
Beginning outstanding balance
1,940

 
3,881

 
1,517

 
3,034

Achieved
(1,373
)
 
(1,387
)
 

 

Awarded
1,206

(1) 
1,053

 
671

 
1,342

Forfeited
(133
)
 
(268
)
 
(248
)
 
(495
)
Ending outstanding balance
1,640

 
3,279

 
1,940

 
3,881

_________________________________________ 
(1) 
Included in the 1.2 million shares awarded during the nine months ended September 2, 2016 were 0.7 million shares awarded for the final achievement of the 2013 Performance Share program. The remaining awarded shares were for the 2016 Performance Share Program.

Summary of Employee Stock Purchase Plan Shares
The expected life of the ESPP shares is the average of the remaining purchase periods under each offering period. The assumptions used to value employee stock purchase rights during the three and nine months ended September 2, 2016 and August 28, 2015 were as follows:
 
Three Months
 
Nine Months
 
2016
 
2015
 
2016
 
2015
Expected life (in years)
0.5 - 2.0
 
0.5 - 2.0
 
0.5 - 2.0
 
0.5 - 2.0
Volatility
26% - 28%
 
 26 - 27%
 
26% - 29%
 
 26 - 30%
Risk free interest rate
0.37% - 0.59%
 
 0.11 - 0.64%
 
0.37% - 1.06%
 
 0.11 - 0.67%
 


19


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Employees purchased 1.9 million shares at an average price of $66.13 and 2.1 million shares at an average price of $52.37 for the nine months ended September 2, 2016 and August 28, 2015, respectively. The intrinsic value of shares purchased during the nine months ended September 2, 2016 and August 28, 2015 was $54.3 million and $54.0 million, respectively. The intrinsic value is calculated as the difference between the market value on the date of purchase and the purchase price of the shares.
Summary of Stock Options 
The Executive Compensation Committee of Adobe’s Board of Directors eliminated the use of stock option grants for all employees and the Board of Directors effective fiscal 2012 and fiscal 2014, respectively. As of September 2, 2016 and November 27, 2015, we had 0.8 million and 1.3 million stock options outstanding, respectively.

Compensation Costs
As of September 2, 2016, there was $529.9 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based awards which will be recognized over a weighted average period of 1.9 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.
Total stock-based compensation costs included in our Condensed Consolidated Statements of Income for the three months ended September 2, 2016 and August 28, 2015 were as follows (in thousands):
 
 
2016
 
2015
Income Statement Classifications
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock and
Performance
Share
Awards
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock and
Performance
Share
Awards 
Cost of revenue—subscription
$
333

 
$
1,554

 
$
258

 
$
1,637

Cost of revenue—services and support
1,221

 
1,861

 
1,277

 
1,425

Research and development
3,336

 
26,388

 
3,468

 
26,378

Sales and marketing
3,940

 
27,798

 
4,540

 
29,146

General and administrative
976

 
17,097

 
1,056

 
16,792

Total
$
9,806

 
$
74,698

 
$
10,599

 
$
75,378

Total stock-based compensation costs included in our Condensed Consolidated Statements of Income for nine months ended September 2, 2016 and August 28, 2015 were as follows (in thousands):
 
 
2016
 
2015
Income Statement Classifications
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock and
Performance
Share
Awards
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock and
Performance
Share
Awards 
Cost of revenue—subscription
$
1,119

 
$
5,115

 
$
1,070

 
$
4,946

Cost of revenue—services and support
4,087

 
5,494

 
3,897

 
4,711

Research and development
10,961

 
81,280

 
11,162

 
78,375

Sales and marketing
12,953

 
85,123

 
13,768

 
84,686

General and administrative
3,423

 
53,049

 
3,652

 
50,744

Total
$
32,543

 
$
230,061

 
$
33,549

 
$
223,462



20


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 9.  STOCKHOLDERS’ EQUITY
Retained Earnings
The changes in retained earnings for the nine months ended September 2, 2016 were as follows (in thousands): 
Balance as of November 27, 2015
$
7,253,431

Net income
769,169

Re-issuance of treasury stock
(307,696
)
Balance as of September 2, 2016
$
7,714,904

We account for treasury stock under the cost method. When treasury stock is re-issued at a price higher than its cost, the difference is recorded as a component of additional paid-in-capital in our Condensed Consolidated Balance Sheets. When treasury stock is re-issued at a price lower than its cost, the difference is recorded as a component of additional paid-in-capital to the extent that there are treasury stock gains to offset the losses. If there are no treasury stock gains in additional paid-in-capital, the losses upon re-issuance of treasury stock are recorded as a reduction of retained earnings in our Condensed Consolidated Balance Sheets.
The components of accumulated other comprehensive income (loss) and activity, net of related taxes, as of September 2, 2016 were as follows (in thousands):
 
November 27,
2015
 
Increase / Decrease
 
Reclassification Adjustments
 
September 2,
2016
Net unrealized gains on available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains on available-for-sale securities
$
2,542

 
$
16,209

 
$
(2,487
)
 
$
16,264

Unrealized losses on available-for-sale securities
(7,095
)
 
5,468

 
505

 
(1,122
)
Total net unrealized gains on available-for-sale securities
(4,553
)
 
21,677

 
(1,982
)
(1) 
15,142

Net unrealized gains / losses on derivative instruments designated as hedging instruments
2,915

 
9,089

 
(9,964
)
(2) 
2,040

Cumulative foreign currency translation adjustments
(167,442
)
 
16,149

 

 
(151,293
)
Total accumulated other comprehensive income (loss), net of taxes
$
(169,080
)
 
$
46,915

 
$
(11,946
)
 
$
(134,111
)
_________________________________________ 
(1) 
Reclassification adjustments for gains / losses on available-for-sale securities are classified in interest and other income (expense), net.
(2) 
Reclassification adjustments for loss on the interest rate lock agreement and gains / losses on other derivative instruments are classified in interest and other income (expense), net and revenue, respectively.

The following table sets forth the taxes related to each component of other comprehensive income for the three and nine months ended September 2, 2016 and August 28, 2015 (in thousands):
 
Three Months
 
Nine Months
 
2016
 
2015
 
2016
 
2015
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains / losses
$
(13
)
 
$
30

 
$
(35
)
 
$
(126
)
Derivatives designated as hedging instruments:
 
 
 
 
 
 
 
Unrealized gains / losses on derivative instruments(1)

 

 

 
6,147

Reclassification adjustments(1)
(151
)
 
(152
)
 
(466
)
 
(362
)
Subtotal derivatives designated as hedging instruments
(151
)
 
(152
)
 
(466
)
 
5,785

Foreign currency translation adjustments
(463
)
 
(8
)
 
882

 
(2,439
)
Total taxes, other comprehensive income
$
(627
)
 
$
(130
)
 
$
381

 
$
3,220

_________________________________________ 

21


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

(1)  
Taxes related to derivative instruments other than the interest rate lock agreement were zero based on the tax jurisdiction where these derivative instruments were executed.
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 the first quarter of fiscal 2015, the Board of Directors approved a new stock repurchase program granting the Company authority to repurchase up to $2 billion in common stock through the end of fiscal 2017.
During the nine months ended September 2, 2016 and August 28, 2015, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $775 million and $500 million, respectively. The prepayment of $775 million during the nine months ended September 2, 2016 was under the current $2 billion authority. Of the prepayment of $500 million during the nine months ended August 28, 2015, $300 million was under the current $2 billion authority and $200 million was under the previous $2 billion authority. We enter into these agreements in order to take advantage of repurchasing shares at a guaranteed discount to the Volume Weighted Average Price (“VWAP”) of our common stock over a specified period of time. We only enter into such transactions when the discount that we receive is higher than the foregone return on our cash prepayments to the financial institutions. There were no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us.
The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval and the average VWAP of our stock during the interval less the agreed upon discount. During the nine months ended September 2, 2016, we repurchased approximately 7.3 million shares at an average price of $93.87 through structured repurchase agreements entered into during fiscal 2015 and the nine months ended September 2, 2016. During the nine months ended August 28, 2015, we repurchased approximately 6.7 million shares at an average price of $75.93 through structured repurchase agreements entered into during fiscal 2014 and the nine months ended August 28, 2015.
For the nine months ended September 2, 2016, the prepayments were classified as treasury stock on our Condensed Consolidated Balance Sheets at the payment date, though only shares physically delivered to us by September 2, 2016 were excluded from the computation of earnings per share. As of September 2, 2016, $131.3 million of prepayment remained under this agreement.
Subsequent to September 2, 2016, as part of our $2 billion stock repurchase program, we entered into a structured stock repurchase agreement with a large financial institution whereupon we provided them with a prepayment of $300 million. This amount will be classified as treasury stock on our Condensed Consolidated Balance Sheets. Upon completion of the $300 million stock repurchase agreement, $500 million remains under our current authority.

NOTE 10.  NET INCOME PER SHARE
 
The following table sets forth the computation of basic and diluted net income per share for the three and nine months ended September 2, 2016 and August 28, 2015 (in thousands, except per share data):
 
Three Months
 
Nine Months
 
2016
 
2015
 
2016
 
2015
Net income
$
270,788

 
$
174,465

 
$
769,169

 
$
406,846

Shares used to compute basic net income per share
498,584

 
498,630

 
499,224

 
498,891

Dilutive potential common shares:
 
 
 
 
 
 
 
Unvested restricted stock and performance share awards
4,633

 
6,298

 
5,373

 
7,145

Stock options
452

 
881

 
538

 
1,088

Shares used to compute diluted net income per share
503,669

 
505,809

 
505,135

 
507,124

Basic net income per share
$
0.54

 
$
0.35

 
$
1.54

 
$
0.82

Diluted net income per share
$
0.54

 
$
0.34

 
$
1.52

 
$
0.80


22


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

For the three and nine months ended September 2, 2016 and August 28, 2015, there were no options to purchase shares of common stock with exercise prices greater than the average fair market value of our stock of $98.12 and $93.35, respectively, and $81.07 and $77.14, respectively, that would have been anti-dilutive.
NOTE 11.  COMMITMENTS AND CONTINGENCIES
Lease Commitments
We occupy three office buildings in San Jose, California where our corporate headquarters are located. We reference these office buildings as the Almaden Tower and the East and West Towers. We own the East and West Tower buildings, lease the Almaden Tower building and own the land under each of them.
The lease agreement for the Almaden Tower is effective through March 2017. We are the investors in the lease receivable related to the Almaden Tower lease in the amount of $80.4 million, which is recorded as investment in lease receivable on our Condensed Consolidated Balance Sheets. As of September 2, 2016, the carrying value of the lease receivable related to the Almaden Tower approximated fair value. Under the agreement for the Almaden Tower, we have the option to purchase the building at any time during the lease term for $103.6 million. If we purchase the building, the investment in the lease receivables may be credited against the purchase price. The residual value guarantee under the Almaden Tower obligation is $89.4 million.
The Almaden Tower lease is subject to standard covenants including certain financial ratios that are reported to the lessor quarterly. As of September 2, 2016, we were in compliance with all of the covenants. In the case of a default, the lessor may demand we purchase the building for an amount equal to the lease balance, or require that we remarket or relinquish the building. If we choose to remarket or are required to do so upon relinquishing the building, we are bound to arrange the sale of the building to an unrelated party and will be required to pay the lessor any shortfall between the net remarketing proceeds and the lease balance, up to the residual value guarantee amount less our investment in lease receivable. The Almaden Tower lease qualifies for operating lease accounting treatment and, as such, the building and the related obligation are not included on our Condensed Consolidated Balance Sheets. 
Royalties
We have royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit sold or a percentage of the underlying revenue.
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. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.
Legal Proceedings
In connection with disputes relating to the validity or alleged infringement of third-party intellectual property rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation may be very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. We may not prevail in any ongoing or future litigation and disputes. Third-party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on unfavorable terms, prevent us from licensing certain of our products or offering certain of our services,

23


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

subject us to injunctions restricting our sale of products or services, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements and service agreements.
In addition to intellectual property disputes, we are subject to legal proceedings, claims and investigations in the ordinary course of business, including claims relating to commercial, employment and other matters. Some of these disputes and legal proceedings may include speculative claims for substantial or indeterminate amounts of damages. We consider all claims on a quarterly basis in accordance with GAAP and based on known facts assess whether potential losses are considered reasonably possible, probable and estimable. Based upon this assessment, we then evaluate disclosure requirements and whether to accrue for such claims in our financial statements. This determination is then reviewed and discussed with our Audit Committee and our independent registered public accounting firm.
We make a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Unless otherwise specifically disclosed in this note, we have determined that no provision for liability nor disclosure is required related to any claim against us because: (a) there is not a reasonable possibility that a loss exceeding amounts already recognized (if any) may be incurred with respect to such claim; (b) a reasonably possible loss or range of loss cannot be estimated; or (c) such estimate is immaterial.
All legal costs associated with litigation are expensed as incurred. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us. It is possible, nevertheless, that our consolidated financial position, cash flows or results of operations could be negatively affected in any particular period by an unfavorable resolution of one or more of such proceedings, claims or investigations.
In connection with our anti-piracy efforts, conducted both internally and through organizations such as the Business Software Alliance, from time to time we undertake litigation against alleged copyright infringers. Such lawsuits may lead to counter-claims alleging improper use of litigation or violation of other laws. We believe we have valid defenses with respect to such counter-claims; however, it is possible that our consolidated financial position, cash flows or results of operations could be negatively affected in any particular period by the resolution of one or more of these counter-claims.
NOTE 12.  DEBT
Notes
In February 2010, we issued $600 million of 3.25% senior notes due February 1, 2015 (the “2015 Notes”) and $900 million of 4.75% senior notes due February 1, 2020 (the “2020 Notes”). Our proceeds were $1.5 billion and were net of an issuance discount of $6.6 million. In addition, we incurred issuance costs of $10.7 million. Both the discount and issuance costs were or are being amortized to interest expense over the respective terms of the 2015 and 2020 Notes using the effective interest method. The 2015 Notes ranked, and 2020 Notes rank, equally with our other unsecured and unsubordinated indebtedness. The effective interest rate including the discount and issuance costs was 3.45% for the 2015 Notes and is 4.92% for the 2020 Notes. Interest is payable semi-annually, in arrears, on February 1 and August 1, and commenced on August 1, 2010. The 2015 Notes were settled on February 1, 2015, as discussed below.
In June 2014, we entered into interest rate swaps with a total notional amount of $900 million designated as a fair value hedge related to our 2020 Notes. The interest rate swaps effectively convert the fixed interest rate on our 2020 Notes to a floating interest rate based on LIBOR. Under the terms of the swap, we will pay monthly interest at the one-month LIBOR interest rate plus a fixed number of basis points on the $900 million notional amount. In exchange, we will receive 4.75% fixed rate interest from the swap counterparties. See Note 5 for further details regarding our interest rate swap derivatives.

In December 2014, prior to issuing new long-term fixed rate debt, we entered into an interest rate lock agreement on a notional amount of $600 million to hedge against the variability of future interest payments due to changes in the benchmark interest rate. This instrument was designated as a cash flow hedge. See Note 5 for further details regarding our interest rate lock agreement.


24


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

In January 2015, we issued $1 billion of 3.25% senior notes due February 1, 2025 (the “2025 Notes”). Our proceeds were approximately $989.3 million which is net of an issuance discount of $10.7 million. In addition, we incurred issuance costs of $7.9 million. Both the discount and issuance costs are being amortized to interest expense over the term of the 2025 Notes using the effective interest method. The 2025 Notes rank equally with our other unsecured and unsubordinated indebtedness. The effective interest rate including the discount, issuance costs and interest rate agreement is 3.67% for the 2025 Notes. Interest is payable semi-annually, in arrears on February 1 and August 1, commencing on August 1, 2015. A portion of the proceeds from this offering was used to repay $600 million in aggregate principal amount of the 2015 Notes plus accrued and unpaid interest due February 1, 2015. The remaining proceeds were used for general corporate purposes.

As of September 2, 2016, our outstanding notes payable consists of the 2020 Notes and 2025 Notes (the “Notes”) with a total carrying value of $1.92 billion. Based on quoted prices in inactive markets, the fair value of the Notes was $2.05 billion as of September 2, 2016. The total fair value of $2.05 billion excludes the effect of fair value hedge of the 2020 Notes for which we entered into interest rate swaps as described above.
We may redeem the Notes at any time, subject to a make-whole premium. In addition, upon the occurrence of certain change of control triggering events, we may be required to repurchase the Notes, at a price equal to 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase. The Notes also include covenants that limit our ability to grant liens on assets and to enter into sale and leaseback transactions, subject to significant allowances. As of September 2, 2016, we were in compliance with all of the covenants.
In February 2016 and August 2016, we made semi-annual interest payments on our 2020 and 2025 Notes each totaling $37.6 million.
Credit Agreement
On March 2, 2012, we entered into a five-year $1 billion senior unsecured revolving credit agreement (the “Credit Agreement”), providing for loans to us and certain of our subsidiaries. Pursuant to the terms of the Credit Agreement, we may, subject to the agreement of the applicable lenders, request up to an additional $500 million in commitments, for a maximum aggregate commitment of $1.5 billion. Loans under the Credit Agreement will bear interest at either (i) LIBOR plus a margin, based on our public debt ratings, ranging from 0.