10-Q 1 adbe10qq317.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 1, 2017

 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,” “smaller reporting company,” and “emerging growth 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
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. 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 22, 2017 was 492,943,014.
 



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 1,
2017
 
December 2,
2016
 
(Unaudited)
 
(*)
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
1,774,550

 
$
1,011,315

Short-term investments
3,593,936

 
3,749,985

Trade receivables, net of allowances for doubtful accounts of $9,112 and $6,214, respectively
1,006,187

 
833,033

Prepaid expenses and other current assets
206,384

 
245,441

Total current assets
6,581,057

 
5,839,774

Property and equipment, net
939,809

 
816,264

Goodwill
5,820,656

 
5,406,474

Purchased and other intangibles, net
420,667

 
414,405

Investment in lease receivable

 
80,439

Other assets
144,626

 
139,890

Total assets
$
13,906,815

 
$
12,697,246

 
 
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
 
Current liabilities:
 

 
 

Trade payables
$
90,327

 
$
88,024

Accrued expenses
932,292

 
739,630

Income taxes payable
56,754

 
38,362

Deferred revenue
2,136,771

 
1,945,619

Total current liabilities
3,216,144

 
2,811,635

Long-term liabilities:
 
 
 

Debt
1,889,218

 
1,892,200

Deferred revenue
68,093

 
69,131

Income taxes payable
173,023

 
184,381

Deferred income taxes
276,271

 
217,660

Other liabilities
113,632

 
97,404

Total liabilities
5,736,381

 
5,272,411

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; 
492,874 and 494,254 shares outstanding, respectively
61

 
61

Additional paid-in-capital
4,988,491

 
4,616,331

Retained earnings
9,072,321

 
8,114,517

Accumulated other comprehensive income (loss)
(98,630
)
 
(173,602
)
Treasury stock, at cost (107,960 and 106,580 shares, respectively), net of reissuances
(5,791,809
)
 
(5,132,472
)
Total stockholders’ equity
8,170,434

 
7,424,835

Total liabilities and stockholders’ equity
$
13,906,815

 
$
12,697,246

_________________________________________ 
(*)
The condensed consolidated balance sheet as of December 2, 2016 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 1,
2017
 
September 2,
2016
 
September 1,
2017
 
September 2,
2016
Revenue:
 
 
 
 
 
 
 
Subscription
$
1,570,336

 
$
1,168,602

 
$
4,437,882

 
$
3,322,560

Product
158,961

 
180,960

 
513,891

 
578,572

Services and support
111,777

 
114,405

 
343,137

 
344,879

Total revenue
1,841,074

 
1,463,967

 
5,294,910

 
4,246,011

 
Cost of revenue:
 

 
 
 
 
 
 
Subscription
168,915

 
116,990

 
452,830

 
339,664

Product
11,709

 
15,435

 
41,530

 
51,490

Services and support
82,298

 
70,276

 
245,259

 
212,198

Total cost of revenue
262,922

 
202,701

 
739,619

 
603,352

Gross profit
1,578,152

 
1,261,266

 
4,555,291

 
3,642,659

 
Operating expenses:
 

 
 
 
 
 
 
Research and development
315,555

 
248,450

 
900,033

 
718,138

Sales and marketing
550,093

 
477,475

 
1,623,488

 
1,415,155

General and administrative
147,402

 
143,364

 
455,139

 
428,010

Amortization of purchased intangibles
19,428

 
22,652

 
57,876

 
60,034

Total operating expenses
1,032,478

 
891,941

 
3,036,536

 
2,621,337

 Operating income
545,674

 
369,325

 
1,518,755

 
1,021,322

 
Non-operating income (expense):
 

 
 
 
 
 
 
Interest and other income (expense), net
13,539

 
2,725

 
25,899

 
12,995

Interest expense
(18,809
)
 
(17,281
)
 
(55,286
)
 
(52,924
)
Investment gains (losses), net
975

 
1,532

 
5,261

 
(2,955
)
Total non-operating income (expense), net
(4,295
)
 
(13,024
)
 
(24,126
)
 
(42,884
)
Income before income taxes
541,379

 
356,301

 
1,494,629

 
978,438

Provision for income taxes
121,810

 
85,513

 
302,224

 
209,269

Net income
$
419,569

 
$
270,788

 
$
1,192,405

 
$
769,169

Basic net income per share
$
0.85

 
$
0.54

 
$
2.41

 
$
1.54

Shares used to compute basic net income per share
493,426

 
498,584

 
494,138

 
499,224

Diluted net income per share
$
0.84

 
$
0.54

 
$
2.38

 
$
1.52

Shares used to compute diluted net income per share
500,398

 
503,669

 
501,060

 
505,135

 
 
 
 
 
 
 
 




4


ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 1,
2017
 
September 2,
2016
 
September 1,
2017
 
September 2,
2016
 
Increase/(Decrease)
 
Increase/(Decrease)
Net income
$
419,569

 
$
270,788

 
$
1,192,405

 
$
769,169

Other comprehensive income (loss), net of taxes:
 
 
 
 
 
 
 
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains / losses on available-for-sale securities
3,545

 
3,055

 
13,234

 
21,677

Reclassification adjustment for recognized gains / losses on available-for-sale securities
(488
)
 
(869
)
 
(894
)
 
(1,982
)
Net increase (decrease) from available-for-sale securities
3,057

 
2,186

 
12,340

 
19,695

Derivatives designated as hedging instruments:
 
 
 
 
 
 
 
Unrealized gains / losses on derivative instruments
1,483

 
13,233

 
3,613

 
9,089

Reclassification adjustment for recognized gains / losses on derivative instruments
30

 
(3,656
)
 
(31,219
)
 
(9,964
)
Net increase (decrease) from derivatives designated as hedging instruments
1,513

 
9,577

 
(27,606
)
 
(875
)
Foreign currency translation adjustments
43,552

 
(12,828
)
 
90,238

 
16,149

Other comprehensive income (loss), net of taxes
48,122

 
(1,065
)
 
74,972

 
34,969

Total comprehensive income, net of taxes
$
467,691

 
$
269,723

 
$
1,267,377

 
$
804,138






5


ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended
 
September 1,
2017
 
September 2,
2016
Cash flows from operating activities:
 
 
 
Net income
$
1,192,405

 
$
769,169

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

 
 
Depreciation, amortization and accretion
244,763

 
249,675

Stock-based compensation
331,401

 
262,382

Deferred income taxes
47,859

 
44,164

Unrealized losses (gains) on investments, net
(3,243
)
 
3,916

Excess tax benefits from stock-based compensation

 
(69,269
)
Other non-cash items
2,606

 
(124
)
Changes in operating assets and liabilities, net of acquired assets and assumed liabilities:
 
 
 
Trade receivables, net
26,461

 
(57,033
)
Prepaid expenses and other current assets
31,824

 
(86,350
)
Trade payables
(68,397
)
 
(10,861
)
Accrued expenses
81,624

 
(5,540
)
Income taxes payable
6,880

 
95,923

Deferred revenue
185,450

 
308,075

Net cash provided by operating activities
2,079,633

 
1,504,127

Cash flows from investing activities:
 

 
 

Purchases of short-term investments
(1,419,411
)
 
(1,813,509
)
Maturities of short-term investments
601,130

 
557,769

Proceeds from sales of short-term investments
978,737

 
698,486

Acquisitions, net of cash acquired
(459,626
)
 
(48,427
)
Purchases of property and equipment
(140,438
)
 
(155,172
)
Purchases of long-term investments and other assets
(25,669
)
 
(56,413
)
Proceeds from sale of long-term investments and other assets
2,034

 
331

Net cash used for investing activities
(463,243
)
 
(816,935
)
Cash flows from financing activities:
 

 
 

Purchases of treasury stock
(800,000
)
 
(775,000
)
Proceeds from reissuance of treasury stock
157,682

 
139,823

Taxes paid related to net share settlement of equity awards
(220,580
)
 
(224,243
)
Excess tax benefits from stock-based compensation

 
69,269

Repayment of capital lease obligations
(1,328
)
 
(86
)
Net cash used for financing activities
(864,226
)
 
(790,237
)
Effect of foreign currency exchange rates on cash and cash equivalents
11,071

 
(5,843
)
Net increase (decrease) in cash and cash equivalents
763,235

 
(108,888
)
Cash and cash equivalents at beginning of period
1,011,315

 
876,560

Cash and cash equivalents at end of period
$
1,774,550

 
$
767,672

Supplemental disclosures:
 

 
 
Cash paid for income taxes, net of refunds
$
211,343

 
$
108,508

Cash paid for interest
$
59,769

 
$
58,182

Non-cash investing activities:
 
 
 
Investment in lease receivable applied to building purchase
$
80,439

 
$

Issuance of common stock and stock awards assumed in business acquisitions
$
10,348

 
$




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 U.S. Securities and Exchange Commission (the “SEC”). Pursuant to these rules and regulations, we have condensed or omitted certain information and footnote disclosures we normally include in our annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In management’s opinion, we have made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present our financial position, results of operations and cash flows. Our interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 2, 2016 on file with the SEC (our “Annual Report”).
Reclassifications
Certain immaterial prior year amounts have been reclassified to conform to current year presentation in the condensed consolidated balance sheets, condensed consolidated statements of income and condensed consolidated statements of cash flows.
Recently Adopted Accounting Guidance
On March 30, 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“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. 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. Early adoption is permitted.
We early adopted this standard during the first quarter of fiscal 2017. As required by the standard, excess tax benefits recognized on stock-based compensation expense were reflected in our condensed consolidated statements of income as a component of the provision for income taxes rather than paid-in capital on a prospective basis. Accordingly, we recorded excess tax benefits within our provision for income taxes, rather than additional paid-in capital upon adoption. The cumulative effect to retained earnings from previously unrecognized excess tax benefits, after offset by the related valuation allowance, was not significant to our condensed consolidated balance sheets.
We also elected to prospectively apply the change in presentation of excess tax benefits wherein excess tax benefits recognized on stock-based compensation expense were classified as operating activities in our condensed consolidated statements of cash flows for the nine months ended September 1, 2017. Prior period classification of cash flows related to excess tax benefits were not adjusted in our condensed consolidated statements of cash flows.
Presentation requirements for cash flows related to employee taxes paid for withheld shares had no impact to all periods presented as such cash flows have historically been presented as financing activities. Further, we did not elect an accounting policy change to record forfeitures as they occur and thus we continue to estimate forfeitures at each period.

7


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Significant Accounting Policies
There have been no other 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 FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either the full retrospective or modified retrospective 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 expect to adopt this updated standard in the first quarter of fiscal 2019 on a modified retrospective basis. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.
While we are continuing to assess all potential impacts of the new standard, we currently believe the most significant impact relates to our accounting for arrangements that include term-based software licenses bundled with maintenance and support. Under current GAAP, the revenue attributable to these software licenses is recognized ratably over the term of the arrangement because VSOE does not exist for the undelivered maintenance and support element as it is not sold separately. The requirement to have VSOE for undelivered elements to enable the separation of revenue for the delivered software licenses is eliminated under the new standard. Accordingly, under the new standard we will be required to recognize as revenue a portion of the arrangement fee upon delivery of the software license. We expect revenue related to our professional services and cloud offerings for business enterprises, individuals and teams to remain substantially unchanged. Due to the complexity of certain of our contracts, the actual revenue recognition treatment required under the new standard for these arrangements may be dependent on contract-specific terms and, therefore, may vary in some instances.
On February 24, 2016, the FASB issued ASU No. 2016-02, Leases, requiring lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases. 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 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.
On August 28, 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging, requiring expanded hedge accounting for both non-financial and financial risk components and refining the measurement of hedge results to better reflect an entity's hedging strategies. The updated standard also amends the presentation and disclosure requirements and changes how entities assess hedge effectiveness. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition with a cumulative effect adjustment recorded to opening retained earnings as of the initial adoption date. The updated standard is effective for us beginning in the first quarter of fiscal 2020 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our 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 1, 2017, as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K for the fiscal year ended December 2, 2016, that are of significance or potential significance to us.

8


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 2.  ACQUISITIONS
On December 19, 2016, we completed our acquisition of TubeMogul, a publicly held video advertising platform company. During the first quarter of fiscal 2017, we began integrating TubeMogul into our Digital Marketing reportable segment.
Under the acquisition method of accounting, the total purchase price was preliminarily allocated to TubeMogul’s net tangible and intangible assets based upon their estimated fair values as of December 19, 2016. During the third quarter of fiscal 2017, we recorded immaterial purchase accounting adjustments based on changes to management’s estimates and assumptions in regards to goodwill and liabilities assumed. The total purchase price for TubeMogul was $560.8 million which was preliminarily allocated to goodwill, that is non-deductible for tax purposes, for $349.0 million, to identifiable intangible assets for $113.1 million and to net assets acquired for $98.7 million. The fair values assigned to assets acquired and liabilities assumed are based on management’s best estimates and assumptions as of the reporting date and are considered preliminary pending finalization of valuation analyses pertaining to intangible assets acquired and tax liabilities assumed including calculation of deferred tax assets and liabilities.
Pro forma financial information has not been presented for this acquisition as the impact to our condensed consolidated financial statements was not material.
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 1, 2017 (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Current assets:
 
 
 
 
 
 
 
Cash
$
413,411

 
$

 
$

 
$
413,411

Cash equivalents:
 
 
 
 
 
 
 
Money market mutual funds
1,344,350

 

 

 
1,344,350

Time deposits
16,789

 

 

 
16,789

Total cash equivalents
1,361,139

 

 

 
1,361,139

Total cash and cash equivalents
1,774,550

 

 

 
1,774,550

Short-term fixed income securities:
 
 
 
 
 
 
 
Asset-backed securities
99,295

 
51

 
(162
)
 
99,184

Corporate bonds and commercial paper
2,427,062

 
8,962

 
(3,000
)
 
2,433,024

Municipal securities
145,850

 
162

 
(51
)
 
145,961

U.S. Treasury securities
917,426

 
14

 
(1,673
)
 
915,767

Total short-term investments
3,589,633

 
9,189

 
(4,886
)
 
3,593,936

Total cash, cash equivalents and short-term investments
$
5,364,183

 
$
9,189

 
$
(4,886
)
 
$
5,368,486



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 December 2, 2016 (in thousands):
 
Amortized
Cost
 
Unrealized
Gains
 
Unrealized
Losses
 
Estimated
Fair Value
Current assets:
 
 
 
 
 
 
 
Cash
$
208,635

 
$

 
$

 
$
208,635

Cash equivalents:
 

 
 
 
 
 
 

Corporate bonds and commercial paper
1,249

 

 

 
1,249

Money market mutual funds
782,210

 

 

 
782,210

Municipal securities
1,301

 

 

 
1,301

Time deposits
17,920

 

 

 
17,920

Total cash equivalents
802,680

 

 

 
802,680

Total cash and cash equivalents
1,011,315

 

 

 
1,011,315

Short-term fixed income securities:
 
 
 
 
 
 
 

Asset-backed securities
111,009

 
95

 
(190
)
 
110,914

Corporate bonds and commercial paper
2,464,769

 
3,135

 
(9,554
)
 
2,458,350

Municipal securities
134,710

 
37

 
(525
)
 
134,222

U.S. agency securities
39,538

 
42

 

 
39,580

U.S. Treasury securities
1,008,195

 
194

 
(1,470
)
 
1,006,919

Total short-term investments
3,758,221

 
3,503

 
(11,739
)
 
3,749,985

Total cash, cash equivalents and short-term investments
$
4,769,536

 
$
3,503

 
$
(11,739
)
 
$
4,761,300


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 1, 2017 and December 2, 2016 (in thousands):
 
2017
 
2016
 
Fair 
Value
 
Gross
Unrealized
Losses
 
Fair 
Value
 
Gross
Unrealized
Losses
Corporate bonds and commercial paper
$
710,735

 
$
(2,497
)
 
$
1,282,076

 
$
(9,474
)
Asset-backed securities
62,235

 
(150
)
 
54,063

 
(189
)
Municipal securities
6,387

 
(23
)
 
114,810

 
(525
)
U.S. Treasury and agency securities
808,221

 
(1,400
)
 
580,529

 
(1,470
)
Total
$
1,587,578

 
$
(4,070
)
 
$
2,031,478

 
$
(11,658
)
 
There were 570 securities and 1,052 securities in an unrealized loss position for less than twelve months at September 1, 2017 and at December 2, 2016, 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 1, 2017 and December 2, 2016 (in thousands):
 
2017
 
2016
 
Fair 
Value
 
Gross
Unrealized
Losses
 
Fair 
Value
 
Gross
Unrealized
Losses
Corporate bonds and commercial paper
$
94,397

 
$
(503
)
 
$
39,162

 
$
(80
)
Asset-backed securities
1,495

 
(12
)
 
1,331

 
(1
)
Municipal securities
10,077

 
(28
)
 

 

U.S. Treasury and agency securities
47,636

 
(273
)
 

 

Total
$
153,605

 
$
(816
)
 
$
40,493

 
$
(81
)
There were 90 securities and 23 securities in an unrealized loss position for more than twelve months at September 1, 2017 and at December 2, 2016, 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 1, 2017 (in thousands):
 
Amortized
Cost
 
Estimated
Fair Value
Due within one year
$
1,079,772

 
$
1,079,092

Due between one and two years
1,353,653

 
1,353,378

Due between two and three years
776,048

 
778,726

Due after three years
380,160

 
382,740

Total
$
3,589,633

 
$
3,593,936

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 1, 2017 and 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 1, 2017.
The fair value of our financial assets and liabilities at September 1, 2017 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
$
1,344,350

 
$
1,344,350

 
$

 
$

Time deposits
16,789

 
16,789

 

 

Short-term investments:
 
 
 
 
 
 
 
Asset-backed securities
99,184

 

 
99,184

 

Corporate bonds and commercial paper
2,433,024

 

 
2,433,024

 

Municipal securities
145,961

 

 
145,961

 

U.S. Treasury securities
915,767

 

 
915,767

 

Prepaid expenses and other current assets:
 
 
 

 
 

 
 

Foreign currency derivatives
11,559

 

 
11,559

 

Other assets:
 
 
 

 
 
 
 
Deferred compensation plan assets
52,554

 
1,622

 
50,932

 

Interest rate swap derivatives
7,564

 

 
7,564

 

Total assets
$
5,026,752

 
$
1,362,761

 
$
3,663,991

 
$

Liabilities:
 

 
 

 
 

 
 

Accrued expenses:
 

 
 

 
 

 
 

Foreign currency derivatives
$
1,410

 
$

 
$
1,410

 
$

Total liabilities
$
1,410

 
$

 
$
1,410

 
$



12


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The fair value of our financial assets and liabilities at December 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
$
1,249

 
$

 
$
1,249

 
$

Money market mutual funds
782,210

 
782,210

 

 

Municipal securities
1,301

 

 
1,301

 

Time deposits
17,920

 
17,920

 

 

Short-term investments:
 

 
 
 
 
 
 
Asset-backed securities
110,914

 

 
110,914

 

Corporate bonds and commercial paper
2,458,350

 

 
2,458,350

 

Municipal securities
134,222

 

 
134,222

 

U.S. agency securities
39,580

 

 
39,580

 

U.S. Treasury securities 
1,006,919

 

 
1,006,919

 

Prepaid expenses and other current assets:
 

 
 

 
 

 
 

Foreign currency derivatives
38,112

 

 
38,112

 

Other assets:
 

 
 

 
 

 
 

Deferred compensation plan assets
42,180

 
1,831

 
40,349

 

Interest rate swap derivatives
13,117

 

 
13,117

 

Total assets
$
4,646,074

 
$
801,961

 
$
3,844,113

 
$

Liabilities:
 

 
 

 
 

 
 

Accrued expenses:
 

 
 

 
 

 
 

Foreign currency derivatives
$
5,246

 
$

 
$
5,246

 
$

Total liabilities
$
5,246

 
$

 
$
5,246

 
$


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.

13


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Our Level 2 over-the-counter foreign currency and interest rate swap derivatives are valued using pricing models and discounted cash flow methodologies based on observable foreign exchange and interest rate data at the measurement date.
Our deferred compensation plan assets consist of money market mutual funds and other mutual funds.
Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

We also have direct investments in privately held companies accounted for under the equity or 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 direct 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 1, 2017 and the three months ended September 2, 2016, we determined there were no other-than-temporary impairments on our direct investments. For the nine months ended September 2, 2016, we determined there were immaterial other-than-temporary impairments on certain of our cost method investments and wrote down the investments to fair value.
The fair value of our senior notes was $2 billion as of September 1, 2017, 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.
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.


14


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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

In countries outside the United States, we transact business in U.S. Dollars and in various other currencies. We may use foreign exchange option contracts or forward contracts to hedge certain cash flow exposures resulting from changes in these foreign currency exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge a portion of our forecasted foreign currency denominated revenue in the normal course of business and accordingly, they are not speculative in nature.
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.
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. In effect, the interest rate swaps convert the fixed interest rate on these senior 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 1, 2017 and December 2, 2016 were as follows (in thousands):
 
2017
 
2016
 
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) 
$
9,487

 
$

 
$
34,355

 
$

Interest rate swap (2)
7,564

 

 
13,117

 

Derivatives not designated as hedging instruments:
 
 
 
 
 
 
 
 Foreign exchange forward contracts (1)
2,072

 
1,410

 
3,757

 
5,246

Total derivatives
$
19,123

 
$
1,410

 
$
51,229

 
$
5,246


_________________________________________ 
(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.
 

15


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our condensed consolidated statements of income for the three and nine months ended September 1, 2017 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) 
$
1,483

 
$

 
$
3,613

 
$

Net gain (loss) reclassified from accumulated
OCI into income, net of tax(2)
$
221

 
$

 
$
31,845

 
$

Net gain (loss) recognized in income(3) 
$
(6,190
)
 
$

 
$
(21,842
)
 
$

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

 
$
2,920

 
$

 
$
6,456

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
)
_________________________________________ 
(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 1, 2017 and December 2, 2016 was $5.82 billion and $5.41 billion, respectively. The increase was due to our acquisition of TubeMogul and, to a lesser extent, foreign currency translation adjustments during the nine months ended September 1, 2017.
Purchased and other intangible assets subject to amortization as of September 1, 2017 and December 2, 2016 were as follows (in thousands): 
 
2017
 
2016
 
Cost
 
Accumulated Amortization
 
Net
 
Cost
 
Accumulated Amortization
 
Net
Purchased technology
$
240,901

 
$
(119,042
)
 
$
121,859

 
$
149,253

 
$
(82,091
)
 
$
67,162

Customer contracts and relationships
$
577,887

 
$
(337,748
)
 
$
240,139

 
$
541,366

 
$
(274,380
)
 
$
266,986

Trademarks
76,255

 
(54,088
)
 
22,167

 
76,355

 
(46,846
)
 
29,509

Acquired rights to use technology
72,167

 
(52,931
)
 
19,236

 
87,403

 
(60,929
)
 
26,474

Localization
1,047

 
(586
)
 
461

 
631

 
(177
)
 
454

Other intangibles
38,693

 
(21,888
)
 
16,805

 
38,693

 
(14,873
)
 
23,820

Total other intangible assets
$
766,049

 
$
(467,241
)
 
$
298,808

 
$
744,448

 
$
(397,205
)
 
$
347,243

Purchased and other intangible assets, net
$
1,006,950

 
$
(586,283
)
 
$
420,667

 
$
893,701

 
$
(479,296
)
 
$
414,405

 
Amortization expense related to purchased and other intangible assets was $39.1 million and $116.3 million for the three and nine months ended September 1, 2017, respectively. Comparatively, 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. Of these amounts $19.5 million and $57.7 million were included in cost of sales for the three and nine months ended September 1, 2017, respectively, and $16.9 million and $54.4 million for the three and nine months ended September 2, 2016, respectively.
As of September 1, 2017, we expect amortization expense in future periods to be as follows (in thousands):
Fiscal Year
 
Purchased
Technology
 
Other Intangible
Assets
Remainder of 2017
$
10,704

 
$
26,673

2018
37,722

 
97,462

2019
33,749

 
69,445

2020
31,540

 
39,594

2021
7,078

 
17,279

Thereafter
1,066

 
48,355

Total expected amortization expense
$
121,859

 
$
298,808


17


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7.  ACCRUED EXPENSES
Accrued expenses as of September 1, 2017 and December 2, 2016 consisted of the following (in thousands):
 
2017
 
2016
Accrued compensation and benefits
$
373,448

 
$
339,487

Accrued media costs
129,602

 
5,144

Sales and marketing allowances 
47,075

 
55,681

Accrued corporate marketing
54,921

 
55,218

Taxes payable
43,079

 
43,113

Royalties payable
39,666

 
25,089

Accrued interest expense
6,781

 
25,805

Other
237,720

 
190,093

Accrued expenses
$
932,292

 
$
739,630


Accrued media costs primarily relate to our advertising platform offerings from TubeMogul. We accrue for media costs related to impressions purchased from third-party ad inventory sources. Other primarily includes general corporate accruals for local and regional expenses. Other is also comprised of deferred rent related to office locations with rent escalations and foreign currency liability derivatives.
NOTE 8.  STOCK-BASED COMPENSATION
Summary of Restricted Stock Units
Restricted stock unit activity for the nine months ended September 1, 2017 and the fiscal year ended December 2, 2016 was as follows (in thousands):
 
2017
 
2016
Beginning outstanding balance
8,316

 
10,069

Awarded
4,675

 
4,440

Released
(3,528
)
 
(5,471
)
Forfeited
(615
)
 
(722
)
Increase due to acquisition
595

 

Ending outstanding balance
9,443

 
8,316

Information regarding restricted stock units outstanding at September 1, 2017 and September 2, 2016 is summarized below:
 
Number of
Shares
(thousands)
 
Weighted
Average
Remaining
Contractual
Life
(years)
 
Aggregate
Intrinsic
Value(*)
(millions)
2017
 
 
 
 
 
Restricted stock units outstanding
9,443

 
1.27
 
$
1,464.2

Restricted stock units vested and expected to vest
8,636

 
1.22
 
$
1,339.1

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

_________________________________________ 
(*) 
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 1, 2017 and September 2, 2016 were $155.06 and $103.57, respectively. 

18


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Summary of Performance Shares 
Our 2017, 2016 and 2015 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 2017, the Executive Compensation Committee approved the 2017 Performance Share Program, the terms of which are similar to prior year performance share programs as discussed above.

In the first quarter of fiscal 2017, the Executive Compensation Committee also certified the actual performance achievement of participants in the 2014 Performance Share Program. Actual performance resulted in participants achieving 198% of target or approximately 1.1 million shares. The shares granted and achieved under the 2014 Performance Share Program fully vested on the three-year anniversary of the grant on January 24, 2017, if not forfeited.

In the first quarter of fiscal 2016, the Executive Compensation Committee 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 three-year anniversary of the grant on January 24, 2016, if not forfeited.

As of September 1, 2017, the shares awarded under our 2017, 2016 and 2015 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 1, 2017 and the fiscal year ended December 2, 2016 (in thousands): 
 
2017
 
2016
 
Shares
Granted
 
Maximum
Shares Eligible
to Receive
 
Shares
Granted
 
Maximum
Shares Eligible
to Receive
Beginning outstanding balance
1,630

 
3,261

 
1,940

 
3,881

Awarded
1,082

(1 
) 
1,040

 
1,206

(2 
) 
1,053

Achieved
(1,135
)
 
(1,147
)
 
(1,373
)
 
(1,387
)
Forfeited
(43
)
 
(86
)
 
(143
)
 
(286
)
Ending outstanding balance
1,534

 
3,068

 
1,630

 
3,261

_________________________________________ 
(1) 
Included in the 1.1 million shares awarded during the nine months ended September 1, 2017 were 0.6 million shares awarded for the final achievement of the 2014 Performance Share program. The remaining awarded shares were for the 2017 Performance Share Program.
(2) 
Included in the 1.2 million shares awarded during the fiscal year ended December 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.


19


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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 1, 2017 and September 2, 2016 were as follows:
 
Three Months
 
Nine Months
 
2017
 
2016
 
2017
 
2016
Expected life (in years)
0.5 - 2.0
 
0.5 - 2.0
 
0.5 - 2.0
 
0.5 - 2.0
Volatility
25% - 27%
 
26% - 28%
 
22% - 27%
 
26% - 29%
Risk free interest rate
1.12% - 1.41%
 
0.37% - 0.59%
 
0.62% - 1.41%
 
0.37% - 1.06%
 

Employees purchased 1.9 million shares at an average price of $77.63 and 1.9 million shares at an average price of $66.13 for the nine months ended September 1, 2017 and September 2, 2016, respectively. The intrinsic value of shares purchased during the nine months ended September 1, 2017 and September 2, 2016 was $97.7 million and $54.3 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 1, 2017 and December 2, 2016, we had 0.3 million and 0.6 million stock options outstanding, respectively.

Compensation Costs
As of September 1, 2017, there was $782.8 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 2.0 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 1, 2017 and September 2, 2016 were as follows (in thousands):
 
 
2017
 
2016
Income Statement Classifications
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock Units and
Performance
Share
Awards
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock Units and
Performance
Share
Awards 
Cost of revenue—subscription
$
628

 
$
3,633

 
$
333

 
$
1,554

Cost of revenue—services and support
1,626

 
2,409

 
1,221

 
1,861

Research and development
4,608

 
43,243

 
3,336

 
26,388

Sales and marketing
4,658

 
36,064

 
3,940

 
27,798

General and administrative
1,140

 
19,033

 
976

 
17,097

Total
$
12,660

 
$
104,382

 
$
9,806

 
$
74,698


20


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Total stock-based compensation costs included in our condensed consolidated statements of income for the nine months ended September 1, 2017 and September 2, 2016 were as follows (in thousands):
 
 
2017
 
2016
Income Statement Classifications
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock Units and
Performance
Share
Awards
 
Option
Grants
and Stock
Purchase
Rights
 
Restricted
Stock Units and
Performance
Share
Awards 
Cost of revenue—subscription
$
1,899

 
$
10,467

 
$
1,119

 
$
5,115

Cost of revenue—services and support
4,850

 
7,151

 
4,087

 
5,494

Research and development
12,884

 
119,068

 
10,961

 
81,280

Sales and marketing
13,832

 
103,982

 
12,953

 
85,123

General and administrative
3,623

 
56,972

 
3,423

 
53,049

Total
$
37,088

 
$
297,640

 
$
32,543

 
$
230,061


NOTE 9.  STOCKHOLDERS’ EQUITY
Retained Earnings
The changes in retained earnings for the nine months ended September 1, 2017 were as follows (in thousands): 
Balance as of December 2, 2016
$
8,114,517

Net income
1,192,405

Reissuance of treasury stock
(234,601
)
Balance as of September 1, 2017
$
9,072,321

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 1, 2017 were as follows (in thousands):
 
December 2,
2016
 
Increase / Decrease
 
Reclassification Adjustments
 
September 1,
2017
Net unrealized gains / losses on available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains on available-for-sale securities
$
3,499

 
$
6,872

 
$
(1,224
)
 
$
9,147

Unrealized losses on available-for-sale securities
(11,565
)
 
6,362

 
330

 
(4,873
)
Total net unrealized gains / losses on available-for-sale securities
(8,066
)
 
13,234

 
(894
)
(1) 
4,274

Net unrealized gains / losses on derivative instruments designated as hedging instruments
21,689

 
3,613

 
(31,219
)
(2) 
(5,917
)
Cumulative foreign currency translation adjustments
(187,225
)
 
90,238

 

 
(96,987
)
Total accumulated other comprehensive income (loss), net of taxes
$
(173,602
)
 
$
107,085

 
$
(32,113
)
 
$
(98,630
)

21


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

_________________________________________ 
(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 1, 2017 and September 2, 2016 (in thousands):
 
Three Months
 
Nine Months
 
2017
 
2016
 
2017
 
2016
Available-for-sale securities:
 
 
 
 
 
 
 
Unrealized gains / losses
$
235

 
$
(13
)
 
$
523

 
$
(35
)
Reclassification adjustments
(214
)
 

 
(323
)
 

Subtotal available-for-sale securities
21

 
(13
)
 
200

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

 

 

 

Reclassification adjustments(1)
(149
)
 
(151
)
 
(582
)
 
(466
)
Subtotal derivatives designated as hedging instruments
(149
)
 
(151
)
 
(582
)
 
(466
)
Foreign currency translation adjustments
1,434

 
(463
)
 
3,081

 
882

Total taxes, other comprehensive income
$
1,306

 
$
(627
)
 
$
2,699

 
$
381

_________________________________________ 
(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. Our Board of Directors has approved our stock repurchase program wherein we were granted authority to repurchase common stock up to a specified amount and period. In the first quarter of fiscal 2017, the Board of Directors approved a new stock repurchase authority to repurchase up to $2.5 billion in common stock through the end of fiscal 2019.
During the nine months ended September 1, 2017 and September 2, 2016, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $800 million and $775 million, respectively. Of the $800 million prepayment during the nine months ended September 1, 2017, $300 million was under the new $2.5 billion stock repurchase authority and the remaining $500 million was under the previous $2 billion stock repurchase 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 1, 2017, we repurchased approximately 6.3 million shares at an average price of $126.58 through structured repurchase agreements entered into during fiscal 2016 and the nine months ended September 1, 2017. 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.

22


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

For the nine months ended September 1, 2017, 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 1, 2017 were excluded from the computation of earnings per share. As of September 1, 2017, $98.8 million of prepayment remained under this agreement.
Subsequent to September 1, 2017, as part of the $2.5 billion stock repurchase authority approved in January 2017, 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, $1.9 billion 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 1, 2017 and September 2, 2016 (in thousands, except per share data):
 
Three Months
 
Nine Months
 
2017
 
2016
 
2017
 
2016
Net income
$
419,569

 
$
270,788

 
$
1,192,405

 
$
769,169

Shares used to compute basic net income per share
493,426

 
498,584

 
494,138

 
499,224

Dilutive potential common shares:
 
 
 
 
 
 
 
Unvested restricted stock units and performance share awards
6,664

 
4,633

 
6,574

 
5,373

Stock options
308

 
452

 
348

 
538

Shares used to compute diluted net income per share
500,398

 
503,669

 
501,060

 
505,135

Basic net income per share
$
0.85

 
$
0.54

 
$
2.41

 
$
1.54

Diluted net income per share
$
0.84

 
$
0.54

 
$
2.38

 
$
1.52

For the three and nine months ended September 1, 2017 and September 2, 2016, there were no options to purchase shares of common stock with exercise prices greater than the average fair market value of our stock of $145.96 and $129.77, respectively, and $98.12 and $93.35, 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, East and West Towers.
During the nine months ended September 1, 2017, we exercised our option to purchase the Almaden Tower for a total purchase price of $103.6 million. Upon purchase, our investment in the lease receivable of $80.4 million was credited against the total purchase price. We capitalized the Almaden Tower as property and equipment on our condensed consolidated balance sheets at $104.2 million, the lesser of cost or fair value, which represented the total purchase price plus other direct costs associated with the purchase. 

As of September 1, 2017, we own the buildings that make up the Almaden, East and West Towers and the underlying land.
Royalties
We have royalty commitments associated with the licensing of certain offerings. Royalty expense is generally based on a dollar amount per unit sold or a percentage of the underlying revenue.

23


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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, 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.

24


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 12.  DEBT
Notes
In February 2010, we issued $900 million of 4.75% senior notes due February 1, 2020 (the “2020 Notes”). Our proceeds were $900 million and were net of an issuance discount of $5.5 million. In addition, we incurred issuance costs of $6.4 million. Both the discount and issuance costs are being amortized to interest expense over the term of the 2020 Notes using the effective interest method. The 2020 Notes rank equally with our other unsecured and unsubordinated indebtedness. The effective interest rate including the discount and issuance costs is 4.92%. Interest is payable semi-annually, in arrears, on February 1 and August 1, and commenced on August 1, 2010.
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 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%. Interest is payable semi-annually, in arrears on February 1 and August 1, and commenced on August 1, 2015. A portion of the proceeds from this offering was used to repay $600 million in aggregate principal amount of previously outstanding senior notes plus accrued and unpaid interest due February 1, 2015. The remaining proceeds were used for general corporate purposes.

As of September 1, 2017, our outstanding notes payable consist of the 2020 Notes and 2025 Notes (the “Notes”) with a total carrying value of $1.89 billion which includes the fair value of the interest rate swap and is net of debt issuance costs. Based on quoted prices in inactive markets, the total fair value of the Notes was $2.00 billion as of September 1, 2017. The total fair value excludes the effect of the 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 1, 2017, we were in compliance with all of the covenants.
In February 2017 and August 2017, 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 0.795% and 1.30% or (ii) the base rate, which is defined as the highest of (a) the agent’s prime rate, (b) the federal funds effective rate plus 0.50% or (c) LIBOR plus 1.00% plus a margin, based on our debt ratings, ranging from 0.00% to 0.30%. Commitment fees are payable quarterly at rates between 0.08% and 0.20% per year, also based on our debt ratings. Subject to certain conditions stated in the Credit Agreement, we and any of our subsidiaries designated as additional borrowers may borrow, prepay and re-borrow amounts under the revolving credit facility at any time during the term of the Credit Agreement.

25


ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The Credit Agreement contains customary representations, warranties, affirmative and negative covenants, including a financial covenant, events of default and indemnification provisions in favor of the lenders. The negative covenants include restrictions regarding the incurrence of liens and indebtedness, certain merger and acquisition transactions, dispositions and other matters, all subject to certain exceptions. The financial covenant, based on a quarterly financial test, requires us not to exceed a maximum leverage ratio.
On March 1, 2013, we exercised an option under the Credit Agreement to extend the maturity date of the Credit Agreement to March 2, 2018. On July 27, 2015, we entered into an amendment to further extend the maturity date to July 27, 2020 and reallocated the facility among the syndicate of lenders that are parties to the Credit Agreement.
The facility will terminate and all amounts owing thereunder will be due and payable on the maturity date unless (a) the commitments are terminated earlier upon the occurrence of certain events, including an event of default, or (b) the maturity date is further extended upon our request, subject to the agreement of the lenders.
As of September 1, 2017, there were no outstanding borrowings under this Credit Agreement and we were in compliance with all covenants.
NOTE 13.  NON-OPERATING INCOME (EXPENSE)
 Non-operating income (expense) for the three and nine months ended September 1, 2017 and September 2, 2016 included the following (in thousands):
 
Three Months
 
Nine Months
 
2017
 
2016
 
2017
 
2016
Interest and other income (expense), net:
 
 
 
 
 
 
 
Interest income
$
17,180

 
$
11,849

 
$
46,553

 
$
34,010

Foreign exchange gains (losses)
(4,140
)
 
(10,001
)
 
(21,620
)
 
(23,005
)
Realized gains on fixed income investment
574

 
943

 
1,224