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, 2006

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

77-0019522

(State or other jurisdiction of

(I.R.S. Employer

incorporation or organization)

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 checkmark 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 (the “Act”) 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 is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Act). Large accelerated filer x Accelerated filer o Non-accelerated filer 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 29, 2006 was 583,343,840.

 




ADOBE SYSTEMS INCORPORATED
FORM 10-Q

TABLE OF CONTENTS

 

 

 

Page No.

 

 

PART I—FINANCIAL INFORMATION

 

 

 

Item 1.

 

Condensed Consolidated Financial Statements:

 

 

 

 

 

Condensed Consolidated Balance Sheets
September 1, 2006 and December 2, 2005

 

3

 

 

 

Condensed Consolidated Statements of Income
Three and Nine Months Ended September 1, 2006 and September 2, 2005

 

4

 

 

 

Condensed Consolidated Statements of Cash Flows
Nine Months Ended September 1, 2006 and September 2, 2005

 

5

 

 

 

Notes to Condensed Consolidated Financial Statements

 

6

 

Item 2.

 

Management’s Discussion and Analysis of Financial
Condition and Results of Operations

 

37

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

52

 

Item 4.

 

Controls and Procedures

 

52

 

 

 

PART II—OTHER INFORMATION

 

 

 

Item 1.

 

Legal Proceedings

 

53

 

Item 1A.

 

Risk Factors

 

54

 

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

 

61

 

Item 5.

 

Other Information

 

61

 

Item 6.

 

Exhibits

 

62

 

Signature

 

67

 

Summary of Trademarks

 

68

 

 

2




PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

 

 

September 1,

 

December 2,

 

 

 

2006

 

2005

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

$

644,754

 

 

$

420,818

 

Short-term investments

 

 

1,341,698

 

 

1,280,016

 

Trade receivables, net

 

 

284,586

 

 

173,245

 

Other receivables

 

 

46,105

 

 

31,504

 

Deferred income taxes

 

 

138,504

 

 

58,710

 

Prepaid expenses and other current assets

 

 

40,907

 

 

44,285

 

Total current assets

 

 

2,496,554

 

 

2,008,578

 

Property and equipment, net

 

 

212,875

 

 

103,549

 

Goodwill

 

 

2,147,557

 

 

118,683

 

Purchased and other intangibles, net

 

 

541,542

 

 

16,477

 

Investment in lease receivable

 

 

126,800

 

 

126,800

 

Other assets

 

 

95,457

 

 

66,228

 

 

 

 

$

5,620,785

 

 

$

2,440,315

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Trade and other payables

 

 

$

38,624

 

 

$

41,042

 

Accrued expenses

 

 

253,389

 

 

226,915

 

Accrued restructuring

 

 

12,618

 

 

70

 

Income taxes payable

 

 

149,557

 

 

154,529

 

Deferred revenue

 

 

103,509

 

 

57,839

 

Total current liabilities

 

 

557,697

 

 

480,395

 

Long-term liabilities

 

 

 

 

 

 

 

Deferred revenue

 

 

21,282

 

 

9,731

 

Deferred income taxes

 

 

95,565

 

 

78,800

 

Accrued restructuring

 

 

24,218

 

 

 

Other liabilities

 

 

8,204

 

 

7,063

 

Total liabilities

 

 

706,966

 

 

575,989

 

Stockholders’ equity:

 

 

 

 

 

 

 

Common stock, $0.0001 par value

 

 

56

 

 

54

 

Additional paid-in-capital

 

 

2,437,694

 

 

1,350,692

 

Retained earnings

 

 

3,161,131

 

 

2,838,566

 

Accumulated other comprehensive income (loss)

 

 

1,762

 

 

(914

)

Treasury stock at cost (18,932 and 102,799 shares, respectively), net of re-issuances

 

 

(686,824

)

 

(2,324,072

)

Total stockholders’ equity

 

 

4,913,819

 

 

1,864,326

 

Total liabilities and stockholders’ equity

 

 

$

5,620,785

 

 

$

2,440,315

 

 

See accompanying Notes to Condensed Consolidated 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,
2006

 

September 2,
2005

 

September 1,
2006

 

September 2,
2005

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

Products

 

 

$

579,185

 

 

 

$

476,054

 

 

$

1,830,905

 

$

1,424,821

 

Services and support

 

 

23,006

 

 

 

10,985

 

 

62,220

 

31,129

 

Total revenue

 

 

602,191

 

 

 

487,039

 

 

1,893,125

 

1,455,950

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

Products

 

 

53,308

 

 

 

21,593

 

 

165,426

 

65,222

 

Services and support

 

 

16,171

 

 

 

5,887

 

 

47,406

 

16,661

 

Total cost of revenue

 

 

69,479

 

 

 

27,480

 

 

212,832

 

81,883

 

Gross profit

 

 

532,712

 

 

 

459,559

 

 

1,680,293

 

1,374,067

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

 

130,440

 

 

 

94,586

 

 

401,268

 

270,681

 

Sales and marketing

 

 

217,203

 

 

 

143,748

 

 

641,418

 

446,094

 

General and administrative

 

 

57,311

 

 

 

37,637

 

 

177,324

 

120,788

 

Restructuring and other charges

 

 

32

 

 

 

 

 

20,251

 

 

Amortization of purchased intangibles

 

 

17,693

 

 

 

 

 

52,111

 

 

Total operating expenses

 

 

422,679

 

 

 

275,971

 

 

1,292,372

 

837,563

 

Operating income

 

 

110,033

 

 

 

183,588

 

 

387,921

 

536,504

 

Non-operating income:

 

 

 

 

 

 

 

 

 

 

 

 

 

Investment loss, net

 

 

(5,113

)

 

 

(2,044

)

 

(3,718

)

(6,299

)

Interest and other income, net

 

 

18,092

 

 

 

12,420

 

 

47,563

 

28,352

 

Total non-operating income

 

 

12,979

 

 

 

10,376

 

 

43,845

 

22,053

 

Income before income taxes

 

 

123,012

 

 

 

193,964

 

 

431,766

 

558,557

 

Provision for income taxes

 

 

28,616

 

 

 

49,048

 

 

109,201

 

111,969

 

Net income

 

 

$

94,396

 

 

 

$

144,916

 

 

$

322,565

 

$

446,588

 

Basic net income per share

 

 

$

0.16

 

 

 

$

0.29

 

 

$

0.54

 

$

0.91

 

Shares used in computing basic net income per share

 

 

586,433

 

 

 

491,710

 

 

594,023

 

489,017

 

Diluted net income per share

 

 

$

0.16

 

 

 

$

0.29

 

 

$

0.53

 

$

0.88

 

Shares used in computing diluted net income per share

 

 

600,882

 

 

 

507,821

 

 

612,791

 

507,860

 

Cash dividends declared per share

 

 

$

 

 

 

$

 

 

$

 

$

0.00625

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

4




ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

 

 

Nine Months Ended

 

 

 

September 1,
2006

 

September 2,
2005

 

Cash flows from operating activities:

 

 

 

 

 

 

 

 

 

Net income

 

 

$

322,565

 

 

 

$

446,588

 

 

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

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

 

216,809

 

 

 

47,880

 

 

Stock compensation expense

 

 

131,023

 

 

 

292

 

 

Deferred income taxes

 

 

7,871

 

 

 

(40,293

)

 

Provision for (recovery of) losses on receivables

 

 

724

 

 

 

(678

)

 

Tax benefit from employee stock option plans

 

 

 

 

 

63,802

 

 

Excess tax benefits from stock based compensation

 

 

(81,587

)

 

 

 

 

Acquired incomplete technology

 

 

2,255

 

 

 

 

 

Net losses on sales and impairments of investments

 

 

12,055

 

 

 

6,318

 

 

Retirements of property and equipment

 

 

 

 

 

1,115

 

 

Changes in operating assets and liabilities, net of acquired assets and liabilities:

 

 

 

 

 

 

 

 

 

Receivables

 

 

(35,403

)

 

 

(28,096

)

 

Other current assets

 

 

21,732

 

 

 

(16,106

)

 

Trade and other payables

 

 

(4,516

)

 

 

(6,070

)

 

Accrued expenses

 

 

(79,591

)

 

 

4,500

 

 

Accrued restructuring

 

 

(36,181

)

 

 

 

 

Income taxes payable

 

 

79,975

 

 

 

28,379

 

 

Deferred revenue

 

 

41,527

 

 

 

469

 

 

Net cash provided by operating activities

 

 

599,258

 

 

 

508,100

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

 

 

Purchases of short-term investments

 

 

(1,084,547

)

 

 

(1,571,668

)

 

Maturities of short-term investments

 

 

275,965

 

 

 

217,855

 

 

Sales of short-term investments

 

 

749,495

 

 

 

966,312

 

 

Acquisitions of property and equipment

 

 

(50,169

)

 

 

(38,106

)

 

Purchases of long-term investments and other assets

 

 

(18,595

)

 

 

(24,338

)

 

Cash received from (paid for) acquisitions

 

 

461,906

 

 

 

(9,541

)

 

Proceeds from sale of equity securities

 

 

8,490

 

 

 

1,241

 

 

Net cash provided by (used for) investing activities

 

 

342,545

 

 

 

(458,245

)

 

Cash flows from financing activities:

 

 

 

 

 

 

 

 

 

Purchase of treasury stock

 

 

(1,164,249

)

 

 

(100,092

)

 

Proceeds from issuance of treasury stock

 

 

360,994

 

 

 

249,665

 

 

Excess tax benefits from stock based compensation

 

 

81,587

 

 

 

 

 

Proceeds from issuance of common stock

 

 

306

 

 

 

 

 

Payment of dividends

 

 

 

 

 

(3,044

)

 

Net cash provided by (used for) financing activities

 

 

(721,362

)

 

 

146,529

 

 

Effect of foreign currency exchange rates on cash and cash equivalents

 

 

3,495

 

 

 

(1,277

)

 

Net increase in cash and cash equivalents

 

 

223,936

 

 

 

195,107

 

 

Cash and cash equivalents at beginning of period

 

 

420,818

 

 

 

259,061

 

 

Cash and cash equivalents at end of period

 

 

$

644,754

 

 

 

$

454,168

 

 

Supplemental disclosures:

 

 

 

 

 

 

 

 

 

Common and treasury stock issued and stock options assumed for acquisition of Macromedia

 

 

$

3,436,725

 

 

 

$

 

 

 

See accompanying Notes to Condensed Consolidated Financial Statements.

5




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(In thousands, except share and per share data)
(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

Basis of Presentation

The accompanying condensed consolidated financial statements include those of Adobe and our subsidiaries, after elimination of all intercompany accounts and transactions. Adobe has prepared the accompanying interim condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, consistent in all material respects with those applied in our Annual Report on Form 10-K for the year ended December 2, 2005, except as disclosed below. The interim financial information is unaudited but reflects all adjustments which are, in the opinion of management, necessary to provide fair condensed consolidated balance sheets, condensed consolidated statements of income and cash flows for the interim periods presented. Such adjustments are normal and recurring except as otherwise noted. The Condensed Consolidated Balance Sheet as of December 2, 2005 is derived from the December 2, 2005 audited financial statements. You should read these interim condensed consolidated financial statements in conjunction with the audited consolidated financial statements in our Annual Report on Form 10-K for the year ended December 2, 2005.

On December 3, 2005, we completed the acquisition of Macromedia, Inc (“Macromedia”). The results of operations of Macromedia have been included in our results of operations beginning in the first quarter of fiscal 2006. See Note 2 of the Condensed Consolidated Financial Statements for pro forma results of operations of Adobe and Macromedia.

Goodwill and Purchased and Other Intangibles

In accordance with Statement of Financial Accounting Standards No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets,” we review our goodwill for impairment annually, or more frequently, if facts and circumstances warrant a review. The provisions of SFAS 142 require that a two-step test be performed to assess goodwill for impairment. First, the fair value of each reporting unit is compared to its carrying value. If the fair value exceeds the carrying value, goodwill is not impaired and no further testing is performed. The second step is performed if the carrying value exceeds the fair value. The implied fair value of the reporting unit’s goodwill must be determined and compared to the carrying value of the goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, an impairment loss equal to the difference will be recorded.

We completed our annual goodwill impairment test during the second quarter of fiscal 2006 and determined that the carrying amount of goodwill was not impaired.

SFAS 142 also requires that intangible assets with definite lives be amortized over their estimated useful life and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets.”

We are currently amortizing acquired intangible assets with definite lives. Purchased technology is amortized over its useful life, which is generally 3 to 4 years, and other intangibles assets are amortized over periods from 1 to 13 years. The amortization expense is classified as cost of product revenue for acquired technology and contracts and operating expenses for all other acquired intangible assets

6




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (Continued)

consisting of patents, trademarks, and customer related intangibles in our consolidated statements of income.

Revenue Recognition

Our revenue is derived from the licensing of software products, consulting, and maintenance and support. We recognize revenue when persuasive evidence of an arrangement exists, we have delivered the product or performed the service, the fee is fixed or determinable and collection is probable.

Product revenue

We recognize our product revenue upon shipment, provided collection is determined to be probable and no significant obligations remain. Our desktop application products revenue from distributors is subject to agreements allowing limited rights of return, rebates and price protection. Our direct sales and OEM sales are also subject to limited rights of return. Accordingly we reduce revenue recognized for estimated future returns, price protection and rebates at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel and other related factors.

We record the estimated costs of providing free technical phone support to customers for our software products.

We record OEM licensing revenue, primarily royalties, when OEM partners ship products incorporating Adobe software, provided collection of such revenue is deemed probable.

Our product-related deferred revenue includes maintenance upgrade revenue and customer advances under OEM license agreements. Our maintenance upgrade revenue for our desktop application products is included in our product revenue line item as the maintenance primarily entitles customers to receive product upgrades. In cases where we provide a specified free upgrade to an existing product, we defer the fair value for the specified upgrade right until the future obligation is fulfilled or when the right to the specified free upgrade expires.

Services and support revenue

Our services and support revenue is composed of consulting, training and maintenance and support, primarily related to the licensing of our Enterprise and Developer Solutions and Mobile and Device Solutions products. Our support revenue also includes technical support and developer support to partners and developer organizations related to our desktop products.

Our consulting revenue is recognized using the proportionate performance method and is measured monthly based on input measures, such as on hours incurred to date compared to total estimated hours to complete, with consideration given to output measures, such as contract milestones when applicable. Our maintenance and support offerings, which entitle customers to receive product upgrades and enhancements or technical support, depending on the offering, are recognized ratably over the term of the arrangement.

7




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (Continued)

Multiple element arrangements

We enter into revenue arrangements in which a customer may purchase a combination of software, upgrades, maintenance and support, and consulting (multiple-element arrangements). When vendor-specific objective evidence (“VSOE”) of fair value exists for all elements, we allocate revenue to each element based on the relative fair value of each of the elements. VSOE of fair value is established by the price charged when that element is sold separately. For maintenance and support, VSOE of fair value is established by renewal rates. For arrangements where VSOE of fair value exists only for the undelivered elements, we defer the full fair value of the undelivered elements and recognize the difference between the total arrangement fee and the amount deferred for the undelivered items as revenue, assuming all other criteria for revenue recognition have been met.

We perform ongoing credit evaluations of our customers’ financial condition and in some cases we require various forms of security. We also maintain allowances for estimated losses on receivables.

Stock-based Compensation

During the first quarter of fiscal 2006, we adopted the provisions of, and account for stock-based compensation in accordance with, the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards No. 123—revised 2004 (“SFAS 123R”), “Share-Based Payment” which replaced` Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” and supersedes APB Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees.” Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period, which is the vesting period. We elected the modified-prospective method, under which prior periods are not revised for comparative purposes. The valuation provisions of SFAS 123R apply to new grants and to grants that were outstanding prior to the effective date and are subsequently modified. Estimated compensation for grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS 123 pro forma disclosures.

The adoption of SFAS 123R had and will have a material impact on our consolidated financial position, results of operations and cash flows. See Note 6 for further information regarding our stock-based compensation assumptions and expenses, including pro forma disclosures for prior periods as if we had recorded stock-based compensation expense.

Upon exercise of stock options or vesting of restricted stock and performance shares, we will issue treasury stock. If treasury stock is not available, common stock will be issued. In order to minimize the impact of on-going dilution from exercises of stock options and vesting of restricted stock and performance shares, we instituted a stock repurchase program. See Note 8 for information regarding our stock repurchase program.

8




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (Continued)

Income Taxes

We use the asset and liability method of accounting for income taxes. Under this method, income tax expense is recognized for the amount of taxes payable or refundable for the current year. In addition, deferred tax assets and liabilities are recognized for expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. We record a valuation allowance to reduce deferred tax assets to an amount for which realization is more likely than not. We also account for any income tax contingencies in accordance with Statement of Financial Accounting Standards No. 5 (“SFAS 5”), “Accounting for Contingencies.”

Recent Accounting Pronouncements

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 (“SFAS 157”), “Fair Value Measurements,” which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. Earlier adoption is permitted, provided the company has not yet issued financial statements, including for interim periods, for that fiscal year. We are currently evaluating the impact of SFAS 157, but do not expect the adoption of SFAS 157 to have a material impact on our consolidated financial position, results of operations or cash flows.

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for fiscal years beginning after December 15, 2006 and as a result, is effective for Adobe in the first quarter of fiscal 2008. We are currently evaluating the impact of FIN 48 on our consolidated financial position, results of operations, and cash flows.

In February 2006, the FASB issued Statement of Financial Accounting Standards No. 155 (“SFAS 155”), “Accounting for Certain Hybrid Financial Instruments” which amends Statement of Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities” and Statement of Financial Accounting Standards No. 140 (“SFAS 140”), “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 155 simplifies the accounting for certain derivatives embedded in other financial instruments by allowing them to be accounted for as a whole if the holder elects to account for the whole instrument on a fair value basis. SFAS 155 also clarifies and amends certain other provisions of SFAS 133 and SFAS 140. SFAS 155 is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring in fiscal years beginning after September 15, 2006. Earlier adoption is permitted, provided the company has

9




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) (Continued)

not yet issued financial statements, including for interim periods, for that fiscal year. We will adopt SFAS 155 in the first quarter of fiscal 2007. We do not expect the adoption of SFAS 155 to have a material impact on our consolidated financial position, results of operations or cash flows.

NOTE 2. ACQUISITIONS

On December 3, 2005, we completed the acquisition of Macromedia, a provider of software technologies that enable the development of a wide range of internet and mobile application solutions, for approximately $3.5 billion. The transaction was accounted for using the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.”

Assets acquired and liabilities assumed were recorded at their fair values as of December 3, 2005. The total $3.5 billion preliminary purchase price is comprised of the following:

Value of Adobe stock issued

 

$

3,209,121

 

Fair value of stock options assumed

 

227,604

 

Direct transaction costs

 

29,060

 

Restructuring costs

 

72,947

 

Total preliminary estimated purchase price

 

$

3,538,732

 

 

As a result of the acquisition, we issued approximately 109.0 million shares of Adobe common stock based on an exchange ratio of 1.38 shares of Adobe common stock for each outstanding share of Macromedia common stock as of December 3, 2005. This fixed exchange ratio gives effect to the two-for-one stock split in the form of a stock dividend paid on May 23, 2005 to the stockholders of Adobe. The average market price per share of Adobe common stock of $29.43 was based on the average of the closing prices for a range of trading days (April 14, 2005 through April 20, 2005) around the announcement date (April 18, 2005) of the proposed transaction.

Under the terms of the merger agreement, each Macromedia stock option that was outstanding and unexercised was converted into an option to purchase Adobe common stock and we assumed that stock option in accordance with the terms of the applicable Macromedia stock option plan and terms of the stock option agreement relating to that Macromedia stock option. Based on Macromedia’s stock options outstanding at December 3, 2005, we converted options to purchase approximately 11.0 million shares of Macromedia common stock into options to purchase approximately 15.1 million shares of Adobe common stock. The fair value of options assumed of $227.6 million was determined using the Black Scholes valuation model. The stock price used in the valuation was $29.43, which was the average of closing prices for a range of trading days (April 14, 2005 through April 20, 2005) around the announcement date (April 18, 2005) of the proposed transaction. The risk-free interest rate used in the valuation was the zero-coupon yield implied from U.S. Treasury securities with equivalent remaining terms. We do not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero was used in the valuation. For fully vested options, the expected term used was one year. We estimated the expected term of unvested options by taking the average of the vesting term remaining and the contractual

10




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 2. ACQUISITIONS (Continued)

term of the option, as illustrated in the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107 (“SAB 107”). The implied volatility of Adobe traded stock options was used for volatility.

Direct transaction costs of $29.1 million include investment banking, legal and accounting fees, and other external costs directly related to the acquisition. As of September 1, 2006, substantially all costs for accounting, legal, and other professional services have been paid.

Restructuring costs of $73.0 million relate primarily to costs for severance, associated benefits, outplacement services, and excess facilities. See Note 7 for further details of the amounts accrued and payments made during 2006.

Purchase Price Allocation

In accordance with SFAS No. 141 the total preliminary purchase price was allocated to Macromedia’s net tangible and intangible assets based upon their estimated fair values as of December 3, 2005. The excess purchase price over the value of the net tangible and identifiable intangible assets was recorded as goodwill. The fair values assigned to tangible and intangible assets acquired and liabilities assumed are based on estimates and assumptions of management. During the third quarter of fiscal 2006, we revised our estimate of certain costs associated with our acquisition of Macromedia, resulting in an increase to goodwill of approximately $4.3 million. The adjustment primarily reflected higher than estimated transaction costs and costs related to closing redundant facilities.

The primary areas of the purchase price allocation that are not yet finalized relate to certain facility costs, assumed liabilities, and goodwill. The following represents the allocation of the preliminary purchase price to the acquired net assets of Macromedia and the associated estimated useful lives:

 

 

Amount

 

Estimated
Useful Life

 

Net tangible assets

 

$

699,059

 

N/A

 

Identifiable intangible assets:

 

 

 

 

 

Acquired product rights

 

365,500

 

4 years

 

Customer contracts and relationships

 

183,800

 

6 years

 

Non-competition agreements

 

500

 

2 years

 

Trademarks

 

130,700

 

5 years

 

Goodwill

 

2,037,039

 

N/A

 

Deferred stock-based compensation

 

122,134

 

2.18 years

Total preliminary estimated purchase price

 

$

3,538,732

 

 

 


                    Estimated weighted-average remaining vesting period.

11




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 2. ACQUISITIONS (Continued)

Net tangible assets—Macromedia’s tangible assets and liabilities as of December 3, 2005 were reviewed and adjusted to their fair value as necessary, including an increase to market value of $18.4 million related to owned land and a building, $11.5 million related to an investment, and $21.5 million for receivables related to future payments from existing customers.

Deferred revenues—Macromedia’s deferred revenue was derived from licenses, maintenance and support, hosting, and consulting contracts. We estimated our obligation related to the deferred revenue using the cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligation plus a normal profit margin. The sum of the costs and operating profit approximates, in theory, the amount that we would be required to pay a third party to assume the support obligation. The estimated costs to fulfill the support obligation were based on the historical direct costs related to providing the support. As a result, we recorded an adjustment to reduce Macromedia’s carrying value of deferred revenue by $49.1 million to $14.9 million, which represents our estimate of the fair value of the contractual obligations assumed.

Identifiable intangible assets—Acquired product rights include developed and core technology and patents. Developed technology relates to Macromedia products across all of their product lines that have reached technological feasibility. Core technology and patents represent a combination of Macromedia’s processes, patents and trade secrets developed through years of experience in design and development of its products. We will amortize the fair value of the acquired product rights based on the pattern in which the economic benefits of the intangible asset will be consumed.

Customer contracts and relationships represent existing contracts and the underlying customer relationships. We will amortize the fair value of these assets based on the pattern in which the economic benefits of the intangible asset will be consumed.

Trademarks primarily relate to the Flash trade name and other product names, which will be amortized based on the pattern in which the economic benefits of the intangible asset will be consumed.

In-process research and development—As of the acquisition date, no amounts were allocated to in-process research and development. In-process research and development is dependent on the status of new projects on the date the acquisition is consummated. Prior to the acquisition date, Macromedia had released new versions of its software products. Accordingly, there were no substantive research and development projects in process on the date the acquisition was consummated.

Goodwill—Approximately $2.0 billion has been allocated to goodwill. Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. In accordance with SFAS 142, goodwill will not be amortized but instead will be tested for impairment at least annually (more frequently if certain indicators are present). The factors that contributed to the recognition of goodwill included securing buyer-specific synergies that increase revenue and profits and are not otherwise available to a marketplace participant, acquiring a talented workforce, and significant cost savings opportunities.

Taxes—As part of our accounting for the Macromedia acquisition, a portion of the overall purchase price was allocated to goodwill and acquired intangible assets. Amortization expense associated with

12




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 2. ACQUISITIONS (Continued)

acquired intangible assets is not deductible for tax purposes. Thus, approximately $186.9 million was established as a deferred tax liability for the future amortization of the intangible assets. In accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes,” the valuation allowance on Macromedia’s financial statements as of December 3, 2005 was reduced by $237.8 million to $16.1 million, to the extent the deferred tax assets are more likely than not realizable.

Any impairment charges made in the future associated with goodwill will not be tax deductible and will result in an increased effective income tax rate in the quarter the impairment is recorded.

Deferred stock-based compensation—Deferred stock-based compensation represents the estimated fair value, measured as of December 3, 2005, of unvested Macromedia stock options and restricted stock assumed. The fair value of unvested options assumed was $117.4 million using the Black Scholes valuation model. The stock price used in the valuation is $34.97, which was the closing price of Adobe shares on December 2, 2005, the last trading day before the close of the acquisition. The risk-free interest rate was the zero coupon yield on December 2, 2005 implied from U.S. Treasury securities with equivalent remaining terms. We do not anticipate paying any cash dividends in the foreseeable future and therefore used an expected dividend yield of zero. We estimate the expected term by taking the average of the vesting term remaining and the contractual term of the option, as illustrated in the SAB 107. The implied volatility of Adobe traded stock options as of December 2, 2005 was used for volatility. The fair value of the unvested restricted stock of $4.8 million was based on the fair value of the underlying shares on the acquisition date.

The assumptions used to value Macromedia deferred compensation are as follows:

 

 

2006

 

Expected term (in years)

 

0.17–6.67

 

Volatility

 

32.9–35.2

%

Risk free interest rate

 

3.97–4.48

%

 

Total deferred stock-based compensation, of $122.1 million, is being amortized to expenses over the remaining vesting periods of the underlying options or restricted stock. See Note 6 for the amortization of deferred stock-based compensation during the third quarter of fiscal 2006.

13




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 2. ACQUISITIONS (Continued)

Pro Forma Results

The unaudited financial information in the table below summarizes the combined results of operations of Adobe and Macromedia, on a pro forma basis, as though the companies had been combined as of the beginning of the period presented. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place on December 4, 2004 or of results that may occur in the future. The pro forma financial information for the three and nine months ended September 2, 2005 includes the following items:

 

 

Three Months

 

Nine Months

 

Amortization of intangible assets

 

 

$

51,167

 

 

 

$

153,507

 

 

Amortization of deferred stock-based compensation

 

 

15,471

 

 

 

54,181

 

 

Restructuring costs

 

 

32

 

 

 

20,251

 

 

Business combination accounting effect on historical support revenue

 

 

8,252

 

 

 

34,137

 

 

 

The unaudited pro forma financial information for the three and nine months ended September 2, 2005 combines the historical results for Adobe for the three and nine months ended September 2, 2005 and the historical results for Macromedia for the three and nine months ended June 30, 2005.

 

 

Three Months

 

Nine Months

 

Net revenues

 

 

$

595,608

 

 

 

$

1,763,323

 

 

Net income

 

 

104,322

 

 

 

271,756

 

 

Basic net income per share

 

 

0.18

 

 

 

0.46

 

 

Diluted net income per share

 

 

0.17

 

 

 

0.44

 

 

 

14




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 3. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Below is our goodwill reported by segment as of September 1, 2006 and December 2, 2005:

 

 

2006

 

2005

 

Creative Solutions

 

$

772,558

 

$

18,763

 

Knowledge Worker Solutions

 

431,184

 

8,395

 

Enterprise and Developer Solutions

 

385,002

 

91,525

 

Mobile and Device Solutions.

 

323,629

 

 

Other

 

235,184

 

 

Total goodwill

 

$

2,147,557

 

$

118,683

 

 

During fiscal 2006, our goodwill increased primarily due to the acquisition of Macromedia. This goodwill was subsequently reduced by $0.1 million primarily for the realization of tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions of vested options assumed and for adjustments made to deferred and current tax balances upon filing the final Macromedia U.S. income tax returns in August 2006. In addition, goodwill also increased by $18.8 million due to the acquisition of TTF in the second quarter of fiscal 2006.

Purchased and other intangible assets, subject to amortization, were as follows as of September 1, 2006:

 

 

Cost

 

Accumulated
Amortization

 

Net

 

Purchased technology

 

$

384,150

 

 

$

(111,244

)

 

$

272,906

 

Localization

 

7,285

 

 

(4,056

)

 

3,229

 

Trademarks

 

130,925

 

 

(20,163

)

 

110,762

 

Other intangibles

 

186,740

 

 

(32,095

)

 

154,645

 

Total other intangible assets

 

324,950

 

 

(56,314

)

 

268,636

 

Total purchased and other intangible assets

 

$

709,100

 

 

$

(167,558

)

 

$

541,542

 

 

Purchased and other intangible assets, subject to amortization, were as follows as of December 2, 2005:

 

 

Cost

 

Accumulated
Amortization

 

Net

 

Purchased technology

 

$

18,785

 

 

$

(11,153

)

 

$

7,632

 

Localization

 

$

20,512

 

 

$

(11,901

)

 

$

8,611

 

Trademarks

 

225

 

 

(82

)

 

143

 

Other intangibles

 

301

 

 

(210)

 

 

91

 

Total other intangible assets

 

$

21,038

 

 

$

(12,193

)

 

$

8,845

 

Total purchased and other intangible assets

 

$

39,823

 

 

$

(23,346

)

 

$

16,477

 

 

16




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 3. GOODWILL AND PURCHASED AND OTHER INTANGIBLES (Continued)

The increase in purchased and other intangible assets during the nine months ended September 1, 2006 was primarily due to the acquisition of Macromedia. See Note 2 for further information regarding this acquisition. Purchased and other intangibles also increased primarily due to the acquisition of TTF in the second quarter of fiscal 2006.

Amortization expense related to purchased and other intangible assets was $54.3 million and $166.2 million for the three and nine months ended September 1, 2006 respectively. Comparatively, amortization expense was $6.2 million and $14.9 million for the three and nine months ended September 2, 2005, respectively. As of September 1, 2006, we expect amortization expense in future periods to be as shown below:

 

 

Purchased

 

Other Intangible

 

Fiscal year

 

 

 

Technology

 

Assets

 

Remainder of 2006

 

 

$

21,214

 

 

 

$

15,593

 

 

2007

 

 

78,718

 

 

 

58,460

 

 

2008

 

 

64,039

 

 

 

55,160

 

 

2009

 

 

56,325

 

 

 

55,139

 

 

2010

 

 

7,063

 

 

 

55,139

 

 

2011

 

 

5,121

 

 

 

29,108

 

 

Thereafter

 

 

40,426

 

 

 

37

 

 

Total expected amortization expense

 

 

$

272,906

 

 

 

$

268,636

 

 

 

NOTE 4. OTHER ASSETS

Other assets consisted of the following as of September 1, 2006 and December 2, 2005:

 

 

2006

 

2005

 

Investments

 

$

57,454

 

$

51,707

 

Security deposits and other

 

11,962

 

7,419

 

Prepaid land lease

 

3,272

 

3,301

 

Prepaid rent

 

3,879

 

3,801

 

Restricted cash

 

5,462

 

 

Unbilled receivables

 

11,056

 

 

Note receivable

 

2,372

 

 

Total other assets

 

$

95,457

 

$

66,228

 

 

The increase in other assets is primarily due to the addition of assets related to our acquisition of Macromedia on December 3, 2005.

We own limited partnership interests in Adobe Ventures which are consolidated in accordance with FASB Interpretation No. 46R (“FIN 46R”) a revision to FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” The partnerships are controlled by Granite Ventures, an independent venture capital firm and sole general partner of Adobe Ventures.

17




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 4. OTHER ASSETS (Continued)

The following table summarizes the net realized gains and losses from our investments for the three and nine months ended September 1, 2006 and September 2, 2005:

 

 

Three Months

 

Nine Months

 

 

 

2006

 

2005

 

2006

 

2005

 

Net losses related to our investments in Adobe Ventures and cost method investments

 

$

(5,013

)

$

(2,081

)

$

(3,558

)

$

(5,906

)

Write-downs due to other-than-temporary declines in value of our marketable equity securities

 

 

 

 

(558

)

Gains from sales of short-term investments

 

 

143

 

 

85

 

Gains (losses) on stock warrants

 

(100

)

(124

)

(160

)

62

 

Other investment gains

 

 

18

 

 

18

 

Total investment loss

 

$

(5,113

)

$

(2,044

)

$

(3,718

)

$

(6,299

)

 

NOTE 5. ACCRUED EXPENSES

Accrued expenses consisted of the following as of September 1, 2006 and December 2, 2005:

 

 

2006

 

2005

 

Compensation and benefits

 

$

119,016

 

$

112,362

 

Sales and marketing allowances

 

16,686

 

16,306

 

Other

 

117,687

 

98,247

 

Total accrued expenses

 

$

253,389

 

$

226,915

 

 

NOTE 6. STOCK-BASED COMPENSATION

Stock Options

Our stock option program is a long-term retention program that is intended to attract, retain and provide incentives for talented employees, officers and directors, and to align stockholder and employee interests. We consider our option programs critical to our operation and productivity. Currently, we grant options from the 1) 2003 Equity Incentive Plan (“2003 Plan”), under which options could be granted to all employees, including executive officers, and outside consultants and 2) the 1996 Outside Directors Stock Option Plan, as amended, under which options are granted automatically under a pre-determined formula to non-employee directors. In addition, our stock option program includes the 2005 Equity Incentive Assumption Plan, from which we currently do not grant options, but may do so in the future. The plans listed above are collectively referred to in the following discussion as “the Plans.” Option vesting periods are generally three to four years for all of the Plans.

Employee Stock Purchase Plan

Our 1997 Employee Stock Purchase Plan (the “ESPP”) allows eligible employee participants to purchase shares of our common stock at a discount through payroll deductions. The ESPP consists of twenty-four-month offering periods with four six-month purchase periods in each offering period.

18




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 6. STOCK-BASED COMPENSATION (Continued)

Employees purchase shares in each purchase period at 85% of the market value of our common stock at either the beginning of the offering period or the end of the purchase period, whichever price is lower.

Restricted Stock

We grant restricted shares and performance awards to employees under our Amended 1994 Performance and Restricted Stock Plan (“Restricted Stock Plan”). The Restricted Stock Plan provides for the granting of restricted stock and/or performance awards to officers and key employees. Restricted stock issued under the Restricted Stock Plan generally vest annually over two to three years but are considered outstanding at the time of grant, as the stockholders are entitled to dividends and voting rights.

Performance Shares

Effective February 2, 2006, the Executive Compensation Committee adopted the 2006 Performance Share Program (the “Program”). The Executive Compensation Committee established the Program to align the new leadership team to achieve key integration milestones and create stockholder value and to retain key executives. All members of Adobe’s executive management team and other key members of senior management are participating in the Program which runs through the end of our fiscal 2007. Awards under the Program were granted in the form of performance shares pursuant to the terms of our 2003 Plan or Restricted Stock Plan. Performance shares granted entitle the recipient to receive fully-vested shares of Adobe common stock upon completion of the performance period subject to attaining identified performance goals, some of which contain discretionary metrics.

Stock Compensation

Beginning with our first quarter of fiscal 2006, we adopted SFAS 123R. See Note 1 for a description of our adoption of SFAS 123R. We currently use the Black-Scholes option pricing model to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behaviors, risk-free interest rate and expected dividends.

We estimate the expected term of options granted by calculating the average term from our historical stock option exercise experience. We estimate the volatility of our common stock by using implied volatility in market traded options in accordance with SAB 107. Our decision to use implied volatility was based upon the availability of actively traded options on our common stock and our assessment that implied volatility is more representative of future stock price trends than historical volatility. We base the risk-free interest rate that we use in the option valuation model on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term on the options. We do not anticipate paying any cash dividends in the foreseeable future and therefore use an expected dividend yield of zero in the option valuation model. We are required to estimate forfeitures at the time of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option

19




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 6. STOCK-BASED COMPENSATION (Continued)

forfeitures and record stock-based compensation expense only for those awards that are expected to vest. All stock-based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.

The expected term of employee stock purchase plan shares is the average of the remaining purchase periods under each offering period.

Prior to the adoption of SFAS 123R, we recognized the estimated compensation cost of restricted stock over the vesting term. The estimated compensation cost is based on the fair value of Adobe’s common stock on the date of grant. We will continue to recognize the compensation cost, net of estimated forfeitures, over the vesting term.

In accordance with SFAS 123R, we will recognize the estimated compensation cost of performance shares, net of estimated forfeitures. The awards are earned upon attainment of identified performance goals, some of which contain discretionary metrics, and are accounted for based upon the fair value of the award at each reporting date. As such, these awards are re-valued based on Adobe’s traded stock price at the end of each reporting period. If the discretion is removed, then the treatment as a variable award stops and the award will be classified as a fixed equity award. The fair value of the awards will be based on the measurement date, which is the date the award becomes fixed. The awards will be subsequently amortized over the remaining performance period.

In addition to estimating expense for grants to Adobe employees, we also estimated deferred compensation related to unvested options assumed in the acquisition of Macromedia (see Note 2 for further information). In accordance with SFAS 123R, deferred compensation expense is classified by functional area on our consolidated statement of income.

The assumptions used to value option grants for the three and nine months ended September 1, 2006 and September 2, 2005 are as follows:

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

2006

 

2005

 

2006

 

2005

 

Expected life (in years)

 

3.7

 

3.0

 

3.7

 

3.0

 

Volatility

 

33.73–36.95

%

34–37

%

30.29–36.95

%

30–37

%

Risk free interest rate

 

4.89–5.15

%

3.90

%

4.30–5.15

%

3.38–3.90

%

 

The assumptions used to value employee stock purchase rights for the three and nine months ended September 1, 2006 and September 2, 2005 are as follows:

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

2006

 

2005

 

2006

 

2005

 

Expected life (in years)

 

1.25

 

1.25

 

1.25

 

1.25

 

Volatility

 

31.86–35.02

%

37

%

30.30–35.02

%

32–37

%

Risk free interest rate

 

5.16–5.26

%

3.58

%

4.32–5.26

%

3.03–3.58

%

 

See Note 2 for the assumptions used to value Macromedia deferred compensation.

20




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 6. STOCK-BASED COMPENSATION (Continued)

Total stock-based compensation recognized on our consolidated statement of income for the three and nine months ended September 1, 2006 is as follows:

Income Statement Classifications

 

 

 

Option Grants
and Stock
Purchase Rights

 

Restricted
Stock and
Performance
Shares

 

Amortization
of Macromedia
Deferred
Compensation

 

Three months:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue—services and support

 

 

$

569

 

 

 

$

 

 

 

$

249

 

 

Research and development

 

 

11,518

 

 

 

466

 

 

 

802

 

 

Sales and marketing

 

 

8,767

 

 

 

212

 

 

 

14,104

 

 

General and administrative

 

 

5,214

 

 

 

441

 

 

 

316

 

 

Total

 

 

$

26,068

 

 

 

$

1,119

 

 

 

$

15,471

 

 

Nine Months:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue—services and support

 

 

$

1,749

 

 

 

$

 

 

 

$

4,547

 

 

Research and development

 

 

32,795

 

 

 

1,012

 

 

 

14,659

 

 

Sales and marketing

 

 

25,081

 

 

 

831

 

 

 

29,206

 

 

General and administrative

 

 

14,519

 

 

 

855

 

 

 

5,769

 

 

Total

 

 

$

74,144

 

 

 

$

2,698

 

 

 

$

54,181

 

 

 

The following table sets forth the pro forma amounts of net income and net income per share, for the three and nine months ended September 2, 2005, that would have resulted if we had accounted for our employee stock plans under the fair value recognition provisions of SFAS 123:

 

 

Three
Months

 

Nine
Months

 

Net income:

 

 

 

 

 

As reported

 

$

144,916

 

$

446,588

 

Add: Stock-based compensation expense for employees included in reported net income, net of related tax effects

 

72

 

189

 

Less: Total stock-based compensation expense for employees determined under the fair value based method, net of related tax effects

 

(24,531

)

(66,550

)

Pro forma

 

$

120,457

 

$

380,227

 

Basic net income per share:

 

 

 

 

 

As reported

 

$

0.29

 

$

0.91

 

Pro forma

 

$

0.24

 

$

0.78

 

Diluted net income per share:

 

 

 

 

 

As reported

 

$

0.29

 

$

0.88

 

Pro forma

 

$

0.24

 

$

0.75

 

 

21




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 6. STOCK-BASED COMPENSATION (Continued)

Prior to the adoption of SFAS 123R, we presented all tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions as operating cash flows on our consolidated statement of cash flows. SFAS 123R requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Total cash flow will remain unchanged from what would have been reported under prior accounting rules.

As of September 1, 2006, there was $150.7 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based payments granted to Adobe employees. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures. Additionally, as of September 1, 2006, there was $71.3 million of unamortized deferred compensation, related to the acquisition of Macromedia, which will be recognized over a weighted average period of 1.19 years.

General Stock Option Information

The following table sets forth the summary of option activity under our stock option program for the nine months ended September 1, 2006:

 

 

Options
Available
for Grant

 

Number of
Options
Outstanding

 

Weighted Average
Exercise Price

 

Beginning of period

 

24,294

 

 

65,251

 

 

 

$

21.56

 

 

Granted

 

(11,551

)

 

11,348

 

 

 

28.32

 

 

Exercised

 

¾

 

 

(18,316

)

 

 

16.93

 

 

Canceled

 

4,111

 

 

(4,111

)

 

 

24.89

 

 

Expired

 

(94

)

 

¾

 

 

 

¾

 

 

Due to acquisition

 

270

 

 

15,143

 

 

 

¾

 

 

End of period

 

17,030

 

 

69,315

 

 

 

$

23.59

 

 

Weighted average fair value of options granted

 

$

10.70

 

 

 

 

 

 

 

 

 

 

The difference in shares granted under options available for grant and number of options outstanding is due to performance share grants. See below for information regarding the performance shares. The total intrinsic value of options exercised during the period was $312.8 million. The intrinsic value is calculated as the difference between the market value as of September 1, 2006 and the exercise price of the shares. The market value as of September 1, 2006 was $32.33 as reported by the NASDAQ Global Select Market.

22




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 6. STOCK-BASED COMPENSATION (Continued)

Information regarding the stock options outstanding at September 1, 2006 is summarized below:

Range of Exercise Prices

 

 

 

Number
Outstanding

 

Weighted
Average
Remaining
Contractual Life

 

Weighted
Average
Exercise Price

 

Number
Exercisable

 

Weighted
Average
Exercise Price

 

$0.56 – 13.24

 

 

8,219

 

 

 

3.82 years

 

 

 

$

11.09

 

 

 

7,821

 

 

 

$

11.10

 

 

$13.37 – 15.68

 

 

7,411

 

 

 

3.44 years

 

 

 

13.81

 

 

 

6,946

 

 

 

13.79

 

 

$15.69 – 19.55

 

 

10,649

 

 

 

2.80 years

 

 

 

18.46

 

 

 

9,476

 

 

 

18.36

 

 

$19.64 – 21.04

 

 

2,539

 

 

 

4.46 years

 

 

 

20.39

 

 

 

2,129

 

 

 

20.34

 

 

$21.16 – 21.78

 

 

7,040

 

 

 

5.02 years

 

 

 

21.77

 

 

 

3,926

 

 

 

21.77

 

 

$21.97 – 27.83

 

 

7,004

 

 

 

4.25 years

 

 

 

26.12

 

 

 

4,693

 

 

 

26.68

 

 

$27.85 – 30.79

 

 

9,402

 

 

 

6.74 years

 

 

 

30.28

 

 

 

909

 

 

 

29.52

 

 

$30.80 – 32.42

 

 

12,405

 

 

 

4.76 years

 

 

 

32.19

 

 

 

6,441

 

 

 

32.13

 

 

$32.67 – 60.87

 

 

4,645

 

 

 

6.30 years

 

 

 

37.18

 

 

 

422

 

 

 

35.06

 

 

$68.43 – 68.43

 

 

1

 

 

 

3.83 years

 

 

 

68.43

 

 

 

1

 

 

 

68.43

 

 

 

 

 

69,315

 

 

 

4.54 years

 

 

 

$

23.59

 

 

 

42,764

 

 

 

$

20.09

 

 

 

The aggregate intrinsic value of options outstanding and options exercisable as of September 1, 2006 was $629.1 million and $524.7 million, respectively.

General Restricted Stock and Performance Share Information

Restricted Stock

 

 

 

Non-vested
Shares

 

Weighted Average
Grant Date
Fair Value

 

Beginning of period

 

 

428

 

 

 

$

14.38

 

 

Awarded

 

 

9

 

 

 

39.47

 

 

Released

 

 

(292

)

 

 

22.03

 

 

Forfeited

 

 

(2

)

 

 

29.79

 

 

Due to acquisition

 

 

414

 

 

 

22.35

 

 

End of period

 

 

557

 

 

 

$

10.73

 

 

 

During the nine months ended September 1, 2006, we granted 360,000 performance shares under the Program. Upon achievement of performance goals, the recipients may be eligible to receive up to 540,000 shares. These shares will be issued out of our 2003 Plan and our Restricted Stock Plan.

NOTE 7. RESTRUCTURING AND OTHER CHARGES

In the first quarter of fiscal 2006, pursuant to Board of Directors’ approval, we initiated plans to restructure both the pre-merger operations of Adobe and Macromedia to eliminate certain duplicative activities, focus our resources on future growth opportunities and reduce our cost structure. In connection with the worldwide restructuring plan, we recognized costs related to termination benefits for employee positions that were eliminated and for the closure of duplicative facilities. We also recognized costs related

23




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 7. RESTRUCTURING AND OTHER CHARGES (Continued)

to the cancellation of certain contracts associated with the wind-down of subsidiaries and other service contracts held by Macromedia.

Macromedia Merger Restructuring Charges

A summary of preliminary restructuring activities follows:

 

 

Initial
Restructuring
Charges

 

Cash
Payments

 

Adjustments

 

Balance at
September 1, 2006

 

Termination Benefits

 

 

$

26,608

 

 

$

(25,549

)

 

$

869

 

 

 

$

1,928

 

 

Cost of closing redundant facilities

 

 

32,083

 

 

(7,874

)

 

7,625

 

 

 

31,834

 

 

Cost of contract termination

 

 

3,969

 

 

(3,046

)

 

(699

)

 

 

224

 

 

Other

 

 

2,500

 

 

(1,061

)

 

 

 

 

1,439

 

 

Total

 

 

$

65,160

 

 

$

(37,530

)

 

$

7,795

 

 

 

$

35,425

 

 

 

We completed our acquisition of Macromedia on December 3, 2005. Pursuant to Emerging Issues Task Force Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination,” all restructuring charges related to the Macromedia acquisition are recognized as a part of the purchase price allocation, as discussed in Note 2 and have been accrued for as of September 1, 2006.

Accrued restructuring charges of $35.4 million at September 1, 2006 includes $11.6 million recorded in accrued restructuring, current and $23.8 million, related to long-term facilities obligations, recorded in accrued restructuring, non-current in the accompanying Condensed Consolidated Balance Sheets.Adobe Restructuring Charges

In connection with the worldwide restructuring plan, we recognized costs related to termination benefits for former Adobe employees whose positions were eliminated and for the closure of Adobe facilities. We also recognized costs related to the cancellation of certain contracts held by Adobe. In addition, costs related to the write-off of fixed assets located at facilities that will no longer be used will be recognized in the periods that the respective offices are vacated. We expect to recognize these charges through the first quarter of fiscal 2007.

A summary of exit costs follows:

 

 

Initial
Restructuring
Charges

 

Cash
Payments

 

Adjustments

 

Balance at
September 1, 2006

 

Termination Benefits

 

 

$

18,879

 

 

$

(18,677

)

 

$

166

 

 

 

$

368

 

 

Cost of closing redundant facilities

 

 

 

 

(308

)

 

1,101

 

 

 

793

 

 

Cost of contract termination

 

 

105

 

 

(11

)

 

 

 

 

94

 

 

Total

 

 

$

18,984

 

 

$

(18,996

)

 

$

1,267

 

 

 

$

1,255

 

 

 

24




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 7. RESTRUCTURING AND OTHER CHARGES (Continued)

Pursuant to FASB’s Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” all facility related charges related to the pre-merger operations are expensed and accrued for based upon the cease use date. As of September 1, 2006, accrued restructuring charges of $1.3 million at September 1, 2006 includes $1.0 million recorded in accrued restructuring, current and $0.3 million, related to long-term facilities obligations, recorded in accrued restructuring, non-current in the accompanying Condensed Consolidated Balance Sheets.

Accelio Related Restructuring Charges

In connection with our acquisition of Accelio in the second quarter of fiscal 2002, we recognized $14.5 million in liabilities associated with a worldwide reduction in force of Accelio employees, transaction costs, costs related to closing redundant facilities and terminating contracts and other exit costs associated with the acquisition. As of September 1, 2006, $0.1 million remained in accrued restructuring on the consolidated balance sheet and comprised transaction and facilities costs. Transaction costs primarily relate to the liquidation of Accelio’s subsidiaries and are expected to be paid through fiscal 2006. Facilities costs relate to leases we assumed upon acquisition of Accelio that terminate at various times through September 2006.

NOTE 8. STOCKHOLDERS’ EQUITY

Stock Repurchase Program I—On-going Dilution Coverage

To facilitate our stock repurchase program, designed to return value to our stockholders and minimize dilution from stock issuances, we repurchase shares in the open market and from time to time enter into structured repurchase agreements with third parties.

Authorization to repurchase shares to cover on-going dilution is not subject to expiration. However, this repurchase program is limited to covering net dilution from stock issuances and is subject to business conditions and cash flow requirements as determined by our Board of Directors from time to time.

As part of this program, on April 17, 2005, the Board of Directors approved the use of $1.0 billion for stock repurchase commencing upon the close of the Macromedia acquisition.

During fiscal 2005 and for the nine months ended September 1, 2006, we entered into several structured repurchase agreements with large financial institutions, whereupon we provided the financial institutions with prepayments of $600 million and $1.1 billion, respectively. We entered into these agreements in order to take advantage of repurchasing shares at a guaranteed discount to the Volume Weighted Average Price (“VWAP”) of our stock. 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. For a monthly breakdown of repurchase amounts refer to Part II, Item 2(c) of this filing. The parameters

25




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 8. STOCKHOLDERS’ EQUITY (Continued)

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, 2006, we repurchased 1.7 million shares at an average price of $36.04 through open market repurchases and 34.6 million shares at an average price of $33.82 through these structured repurchase agreements which included prepayments from fiscal 2005. During the nine months ended September 2, 2005, we repurchased 7.5 million shares at an average price of $30.36 through these structured repurchase agreements which included prepayments remaining from fiscal 2004.

For the nine months ended September 1, 2006, the $1.1 billion prepayment was classified as treasury stock on our balance sheet at the payment date, though only shares physically delivered to us by September 1, 2006 are excluded from the denominator in the computation of earnings per share. All outstanding structured repurchase agreements as of September 1, 2006 will expire on or before February 7, 2007. As of September 1, 2006 and December 2, 2005, approximately $85.8 million and $154.9 million respectively, of up-front payments remained under the agreements.

NOTE 9. COMPREHENSIVE INCOME

Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income,” establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Items of other comprehensive income that we currently report are unrealized gains and losses on marketable securities categorized as available-for-sale and foreign currency translation adjustments. We also report gains and losses on derivative instruments qualifying as cash flow hedges.

The following table sets forth the components of comprehensive income, net of income tax expense, for the three and nine months ended September 1, 2006 and September 2, 2005:

 

 

Three Months

 

Nine Months

 

 

 

2006

 

2005

 

2006

 

2005

 

Net income

 

$

94,396

 

$

144,916

 

$

322,565

 

$

446,588

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

 

Change in unrealized gain (loss) on available-for sale securities, net of taxes

 

2,730

 

(292

)

2,595

 

(194

)

Currency translation adjustments

 

20

 

1,973

 

3,495

 

(1,277

)

Net gain (loss) in derivative instruments, net of taxes

 

1,903

 

(5,015

)

(3,414

)

949

 

Other comprehensive income (loss)

 

4,653

 

(3,334

)

2,676

 

(522

)

Total comprehensive income, net of taxes

 

$

99,049

 

$

141,582

 

$

325,241

 

$

446,066

 

 

Note 10. Net Income per Share

Basic net income per share is computed using the weighted average number of common shares outstanding for the period, excluding unvested restricted stock. Diluted net income per share is based upon the weighted average common shares outstanding for the period plus dilutive potential common shares, including unvested restricted common stock and stock options using the treasury stock method.

26




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

Note 10. Net Income per Share (Continued)

The following table sets forth the computation of basic and diluted net income per share for the three and nine months ended September 1, 2006 and September 2, 2005:

 

 

Three Months

 

Nine Months

 

 

 

2006

 

2005

 

2006

 

2005

 

Net income

 

$

94,396

 

$

144,916

 

$

322,565

 

$

446,588

 

Shares used to compute basic net income per share

 

586,433

 

491,710

 

594,023

 

489,017

 

Dilutive potential common shares:

 

 

 

 

 

 

 

 

 

Unvested restricted stock

 

35

 

36

 

35

 

36

 

Stock options

 

14,414

 

16,075

 

18,733

 

18,807

 

Shares used to compute diluted net income per share

 

600,882

 

507,821

 

612,791

 

507,860

 

Basic net income per share

 

$

0.16

 

$

0.29

 

$

0.54

 

$

0.91

 

Diluted net income per share

 

$

0.16

 

$

0.29

 

$

0.53

 

$

0.88

 

 

27




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 10. NET INCOME PER SHARE (Continued)

For the three and nine months ended September 1, 2006 options to purchase approximately 27.7 million and 16.7 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $30.21 and $34.38, respectively, were not included in the calculation because the effect would have been anti-dilutive. Comparatively, for the three and nine months ended September 2, 2005 options to purchase approximately 16.7 million and 10.3 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $28.78 and $30.23, respectively, were excluded from the calculation because the effect would have been anti-dilutive.

NOTE 11. COMMITMENTS AND CONTINGENCIES

Lease Commitments

We lease certain facilities and some of our equipment under noncancelable operating lease arrangements that expire at various dates through 2025. We also have one land lease that expires in 2091.

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.”

In December 2003, upon completion of construction, we began a five year lease agreement for the Almaden tower. Under the agreement, we have the option to purchase the building at any time during the lease term for the lease balance, which is approximately $103.0 million. The maximum recourse amount (“residual value guarantee”) under this obligation is $90.8 million.

In August 2004, we extended the lease agreement for our East and West towers for an additional five years with an option to extend for an additional five years solely at Adobe’s election. As part of the lease extension, we purchased a portion of the lease receivable of the lessor for $126.8 million, which is recorded as an investment in lease receivable on our consolidated balance sheet. This purchase may be credited against the residual value guarantee if we purchase the properties or repaid from the sale proceeds if the properties are sold to third parties. Under the agreement for the East and West towers, we have the option to purchase the buildings at any time during the lease term for the lease balance, which is approximately $143.2 million. The maximum recourse amount (“residual value guarantee”) under this obligation is $126.8 million.

These two leases are both subject to standard covenants including liquidity, leverage and profitability ratios that are reported to the lessors quarterly. As of September 1, 2006, we were in compliance with all covenants. In the case of a default, the lessor may demand we purchase the buildings for an amount equal to the lease balance, or require that we remarket or relinquish the buildings. Both leases qualify for operating lease accounting treatment under Statement of Financial Accounting Standards No. 13, “Accounting for Leases,” and, as such, the buildings and the related obligations are not included on our consolidated balance sheet. We utilized this type of financing in order to access bank-provided funding at the most favorable rates and to provide the lowest total cost of occupancy for the headquarter buildings. At the end of the lease term, we can extend the lease for an additional five year term (for the East and West towers lease only), purchase the buildings for the lease balance, remarket or relinquish the buildings. If we choose to remarket or are required to do so upon relinquishing the buildings, we are bound to arrange the

28




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 11. COMMITMENTS AND CONTINGENCIES (Continued)

sale of the buildings 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 maximum recourse amount.

Royalties

We have certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue.

Guarantees

The lease agreements for our corporate headquarters provide for residual value guarantees. Under FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” the fair value of a residual value guarantee in lease agreements entered into after December 31, 2002, must be recognized as a liability on our consolidated balance sheet. As such, we recognized a $5.2 million liability related to the East and West towers lease that was extended in August 2004. This liability is recorded in other long-term liabilities with the offsetting entry recorded as prepaid rent in other assets. The balance will be amortized to the income statement over the life of the lease. As of September 1, 2006, the unamortized portion of the fair value of the residual value guarantee remaining in other long-term liabilities and prepaid rent was $3.0 million.

Indemnifications

In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. 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 limits 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.

As part of our limited partnership interests in Adobe Ventures, we have provided a general indemnification to Granite Ventures, an independent venture capital firm and sole general partner of Adobe Ventures, for certain events or occurrences while Granite Ventures is, or was serving, at our request in such capacity provided that Granite Ventures acts in good faith on behalf of the partnerships. We are unable to develop an estimate of the maximum potential amount of future payments that could

29




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 11. COMMITMENTS AND CONTINGENCIES (Continued)

Rpotentially result from any hypothetical future claim, but believe the risk of having to make any payments under this general indemnification to be remote.

Legal Proceedings

On September 6, 2002, Plaintiff Fred B. Dufresne filed suit against Adobe, Microsoft Corporation, Macromedia, Inc. and Trellix Corporation in the U.S. District Court, District of Massachusetts, alleging infringement of U.S. Patent No. 5,835,712, entitled “Client-Server System Using Embedded Hypertext Tags for Application and Database Development.” The Plaintiff’s complaint asserts that “defendants have infringed, and continue to infringe, one or more claims of the ‘712 patent by making, using, selling and/or offering for sale, inter alia, products supporting Microsoft Active Server Pages technology.” Plaintiff seeks unspecified compensatory damages, preliminary and permanent injunctive relief, trebling of damages for “willful infringement,” and fees and costs. We believe the action has no merit and are vigorously defending against it.

On June 13, 2005, Plaintiff Steve Staehr filed a shareholder derivative action entitled “Steve Staehr, Derivatively on Behalf of Adobe Systems Incorporated v. Bruce R. Chizen, et. al.,” in the Superior Court of the State of California for the County of Santa Clara against Adobe’s directors and naming Adobe as a nominal defendant. The complaint alleges that the defendants breached their fiduciary duties of loyalty and due care and caused Adobe to waste corporate assets by failing to renegotiate or terminate the acquisition agreement with Macromedia following the announcement by Macromedia that it would restate its financial results for the fiscal years ended March 31, 1999 through 2004. On August 18, 2005, Plaintiff amended his complaint to add a purported class action in which Plaintiff seeks, among other things, unspecified monetary damages, attorneys’ fees and certain forms of equitable relief. On May 9, 2006, Plaintiff filed a third amended complaint, to which defendants demurred. A hearing on the demurrer was held on July 7, 2006 and the court granted the defendant’s motion and dismissed the complaint with prejudice.

In connection with our anti-piracy efforts, conducted both internally and through 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 local law and have recently increased in frequency, especially in Latin American countries. 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 affected in any particular period by the resolution of one or more of these counter-claims.

One such case is Consultores en Computación y Contabilidad, S.C. (“CCC”) v. Microsoft, Adobe, Symantec, and Autodesk (the “Defendants”). On March 1, 2002, CCC, a Mexican hardware/software reseller, filed a lawsuit in the Mexico Court of First Instance against the Defendants (all members of the Business Software Alliance). CCC had previously been the target of a criminal anti-piracy enforcement action carried out by the Mexican police authorities on the basis of a piracy complaint filed by the Defendants based on evidence provided to the Defendants. CCC alleged in the lawsuit that it had suffered damages to its reputation as a result of the enforcement action. CCC did not claim economic damages. On

30




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 11. COMMITMENTS AND CONTINGENCIES (Continued)

November 11, 2002, the trial court judge ruled in favor of the Defendants, holding that no moral damage occurred. After subsequent appeals which were favorable to the Defendants, a court of appeals held that the Defendants were liable to CCC for “moral” damages, and the court remanded the case to the Court of First Instance for a determination of the amount. In December 2005, the Court of First Instance awarded CCC $90 million in damages. The Defendants are appealing the verdict, as are the plaintiffs who seek additional damages. If, after all appeals have been exhausted, the existing verdict stands and is enforceable, Adobe would be responsible for approximately $15 million of the judgment. In August 2006, we entered into a settlement agreement with CCC, which did not have a material effect on our financial statements.

From time to time, in addition to those identified above, Adobe is subject to legal proceedings, claims, investigations and proceedings in the ordinary course of business, including claims of alleged infringement of third-party patents and other intellectual property rights, commercial, employment and other matters. In accordance with U.S. generally accepted accounting principles, Adobe makes 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. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against Adobe. It is possible, nevertheless, that our consolidated financial position, cash flows or results of operations could be affected by the resolution of one or more of such contingencies.

NOTE 12. FINANCIAL INSTRUMENTS

In accordance with Statement of Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities” we recognize derivative instruments and hedging activities as either assets or liabilities on the balance sheet 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.

Economic Hedging—Hedges of Forecasted Transactions

We use foreign exchange option contracts to hedge certain operational (“cash flow”) exposures resulting from changes in foreign currency exchange rates. Such cash flow exposures result from portions of our forecasted revenues denominated in currencies other than the U.S. dollar, primarily the Japanese yen and the Euro. These foreign exchange contracts, carried at fair value, may have maturities between one and twelve months. The maximum original duration of any option contract is twelve months. We enter into these foreign exchange contracts to hedge forecasted product licensing 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) until the forecasted transaction occurs.

31




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 12. FINANCIAL INSTRUMENTS (Continued)

The following is a summary of the existing gains that are currently included in accumulated other comprehensive income. These amounts represent the fair value of our cash flow hedge contracts that were still open as of the periods below.

Gain (Loss) on Hedges of Forecasted Transactions:

Balance Sheet

 

 

Other Comprehensive
Income (Loss)

 

 

 

September 1,

 

December 2,

 

 

 

2006

 

2005

 

Recognized but Unrealized—Open Transactions:

 

 

 

 

 

 

 

 

 

Net unrealized gain remaining in other accumulated comprehensive income

 

 

$

1,903

 

 

 

$

5,317

 

 

 

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, the related hedge gains and losses on the cash flow hedge are reclassified from accumulated other comprehensive income (loss) to interest and other income (loss) on the consolidated statement of income at that time. For the three and nine months ended September 1, 2006 and September 2, 2005, there were no such gains or losses recognized in other income relating to hedges of forecasted transactions that did not occur.

Pursuant to SFAS 133, we evaluate hedge effectiveness prospectively and retrospectively and record any ineffective portion of the hedging instruments in other income (loss) on the consolidated income statement. The net gain (loss) recognized in other income for cash flow hedges due to hedge ineffectiveness was insignificant for the three and nine months ended September 1, 2006 and September 2, 2005. The time value of purchased derivative instruments is recorded in other income (loss).

32




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 12. FINANCIAL INSTRUMENTS (Continued)

A summary of the amounts included on the consolidated income statement due to occurrence of the hedged transaction and or time value degradation on open hedge transactions is as follows:

Income Statement

 

 

Three Months Ended

 

 

 

September 1, 2006

 

September 2, 2005

 

 

 

Revenue

 

Other
Income (Loss)

 

Revenue

 

Other
Income (Loss)

 

Gain (loss) on completed hedge transactions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain reclassified from other accumulated comprehensive income to revenue

 

 

$

210

 

 

 

$

 

 

$

5,351

 

 

$

 

 

Net realized loss from the cost of purchased options

 

 

 

 

 

(2,706

)

 

 

 

(1,061

)

 

Gain on open hedge transactions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net unrealized gain from time value degradation on open cash flow hedge transactions

 

 

 

 

 

1,046

 

 

 

 

233

 

 

 

 

 

$

210

 

 

 

$

5,351

 

 

$

(1,660

)

 

$

(828

)

 

 

 

 

Nine Months Ended

 

 

 

September 1, 2006

 

September 2, 2005

 

 

 

Revenue

 

Other
Income (Loss)

 

Revenue

 

Other
Income (Loss)

 

Gain (loss) on completed hedge transactions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain reclassified from other accumulated comprehensive income to revenue

 

 

$

3,301

 

 

 

$

 

 

 

$

5,351

 

 

 

$

 

 

Net realized loss from the cost of purchased options

 

 

 

 

 

(6,419

)

 

 

 

 

 

(5,567

)

 

Gain (loss) on open hedge transactions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net unrealized gain (loss) from time value degradation on open cash flow hedge transactions

 

 

 

 

 

(1,800

)

 

 

 

 

 

2,915

 

 

 

 

 

$

3,301

 

 

 

$

(8,219

)

 

 

$

5,351

 

 

 

$

(2,652

)

 

 

Balance Sheet Hedging—Hedging of Foreign Currency Assets and Liabilities

We hedge our net recognized foreign currency assets and liabilities with forward foreign exchange contracts to reduce the risk that our earnings and cash flows will be adversely affected by changes in foreign currency exchange rates. These derivative instruments hedge assets and liabilities that are denominated in foreign currencies and are carried at fair value with changes in the fair value recorded as other income (loss). These derivative instruments 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. At September 1, 2006, the outstanding balance sheet hedging derivatives had maturities of 90 days or less.

33




ADOBE SYSTEMS INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(In thousands, except share and per share data)
(Unaudited)

NOTE 12. FINANCIAL INSTRUMENTS (Continued)

Net gains (losses) recognized in other income (loss) relating to balance sheet hedging for the three and nine months ended September 1, 2006 and September 2, 2005 were as follows:

 

 

Three Months