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 March 2, 2007

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)

 

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 March 30, 2007 was 588,006,207.

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 March 2, 2007 and December 1, 2006				3
		Condensed Consolidated Statements of Income Quarters Ended March 2, 2007 and March 3, 2006				4
		Condensed Consolidated Statements of Cash Flows Quarters Ended March 2, 2007 and March 3, 2006				5
		Notes to Condensed Consolidated Financial Statements				6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations				22
Item 3.		Quantitative and Qualitative Disclosures About Market Risk				32
Item 4.		Controls and Procedures				32
PART II—OTHER INFORMATION
Item 1.		Legal Proceedings				34
Item 1A.		Risk Factors				34
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds				42
Item 5.		Other Information				42
Item 6.		Exhibits				44
Signature						50
Summary of Trademarks						51

 

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PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADOBE SYSTEMS INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
(Unaudited)

 

See accompanying Notes to Condensed Consolidated Financial Statements.

3

ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

 

See accompanying Notes to Condensed Consolidated Financial Statements.

4

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

 

See accompanying Notes to Condensed Consolidated Financial Statements.

5

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

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The Company has prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the Commission). Pursuant to these rules and regulations, the Company has condensed or omitted certain information and footnote disclosures it normally includes in its annual consolidated financial statements prepared in accordance with generally accepted accounting principles (GAAP). In management’s opinion, the Company has made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present its financial position, results of operations and cash flows. The Company’s interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in Adobe’s Annual Report on Form 10-K/A for the fiscal year ended December 1, 2006 on file with the Commission.

There have been no significant changes in our significant accounting policies during the three months ended March 2, 2007 as compared to the significant accounting policies described in our Annual Report on Form 10-K/A for the fiscal year ended December 1, 2006.

Reclassification

Certain amounts in the first quarter of fiscal year ended December 1, 2006 (fiscal year 2006) as reported in the Consolidated Statements of Cash Flows have been revised. Specifically, in the first quarter of fiscal 2006, there were revisions and reclassifications totaling ($0.4) million to operating activities, $5.0 million to investing activities and ($4.5) million to financing activities. These revisions and reclassifications related to the following:

·       Prepaid expenses related to the Macromedia acquisition have been reclassified from Net Cash Provided by Operating Activities to Net Cash Provided by Investing Activities.

·       The amortization of premium on available for sale securities have been reclassified from Net Cash Provided by Investing Activities to Net Cash Provided by Operating Activities.

·       Excess tax benefits from stock-based compensation have been reclassified from Net Cash Provided by Operating Activities to Net Cash Used for Financing Activities.

Recent Accounting Pronouncements

With the exception of the financial accounting standards board statement defined below, there have been no significant changes in recent accounting pronouncements during the three months ended March 2, 2007 as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K/A for the fiscal year ended December 1, 2006.

In February 2007, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits companies to choose to measure certain financial instruments and certain other items at fair value. The standard requires that unrealized gains and losses on

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

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)

items for which the fair value option has been elected be reported in earnings. SFAS 159 is effective for the company beginning in the first quarter of fiscal year 2008, although earlier adoption is permitted. The company is currently evaluating the impact that SFAS 159 will have on its consolidated financial statements.

NOTE 2. ACQUISITIONS

On December 3, 2005, we completed the acquisition of Macromedia, a provider of software technologies that enables the development of a wide range of internet and mobile application solutions. The acquisition of Macromedia accelerated our strategy of delivering an industry-defining technology platform that provided more powerful solutions for engaging people with digital information.

The total purchase price was allocated to Macromedia’s net tangible and identifiable intangible assets based upon their estimated fair values as of December 3, 2005. The total purchase price for Macromedia was approximately $3.5 billion, which consisted of 109.0 million shares of Adobe common stock valued at $3.2 billion issued in exchange for 100% of Macromedia outstanding common stock, $227.6 million for the fair value of Macromedia options assumed, $29.1 million for transaction costs, and $72.7 million for restructuring costs. In allocating the purchase price based on fair values, we recorded $713.2 million in net tangible assets, $680.5 million in identifiable intangible assets, $146.2 million in stock-based compensation, and $2.0 billion in goodwill.

During the first quarter of fiscal 2007 we completed an acquisition for cash consideration of $3.9 million. This acquisition was not material to our consolidated balance sheet and results of operations.

NOTE 3. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Below is our goodwill reported by segment as of December 1, 2006 and March 2, 2007:

*                    All goodwill in our Other segments relates to the Platform segment.

Shown above in the column labeled Other are primarily immaterial revisions to the valuation of Macromedia assumed options which reduced goodwill and additional paid-in capital at March 2, 2007.

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

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

Amortization expense related to purchased and other intangible assets was $48.7 million for the first quarter of fiscal 2007 as compared to $57.0 million in the first quarter of fiscal 2006. Of these amounts, $27.9 million and $34.0 million are included in cost of sales for the three months ended March 2, 2007 and March 3, 2006 respectively. Purchased and other intangible assets, subject to amortization, were as follows as of March 2, 2007:

 

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

 

As of March 2, 2007, we expect amortization expense in future periods to be as shown below:

 

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

NOTE 4. OTHER ASSETS

Other assets consisted of the following as of March 2, 2007 and December 1, 2006:

 

Included in investments are our limited partnership interests in Adobe Ventures which are consolidated in accordance with FASB Interpretation No. 46R, a revision to FASB Interpretation No. 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. Investments also include our direct investments which are accounted for under the cost method.

NOTE 5. TRADE AND OTHER PAYABLES AND ACCRUED EXPENSES

Trade and other payables consisted of the following as of March 2, 2007 and December 1, 2006:

 

Accrued expenses consisted of the following as of March 2, 2007 and December 1, 2006:

 

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. 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

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

NOTE 6. STOCK-BASED COMPENSATION (Continued)

includes the 2005 Equity Incentive Assumption Plan, from which we currently do not grant options, but may do so. 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. At the end of the first quarter of fiscal 2007, the number of shares outstanding was 64.5 million.

The total intrinsic value of options exercised during the period was $69.3 million. The intrinsic value is calculated as the difference between the market value on the date of exercise and the exercise price of the shares.

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. 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 stock awards and units 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 four years.

Restricted stock awards are considered outstanding at the time of grant, as the stockholders are entitled to dividends and voting rights. At the end of the first quarter of fiscal 2007, the number of shares granted but unreleased was less than 0.1 million.

Restricted stock units are not considered outstanding at the time of grant, as the holders of these units are not entitled to dividends and voting rights. At the end of the first quarter of fiscal 2007, the number of shares granted, but unreleased was 1.3 million.

Neither restricted stock awards nor restricted stock units are considered outstanding in the computation of basic earnings per share.

Performance Shares

Effective February 2, 2006, the Executive Compensation Committee adopted the 2006 Performance Share Program (the “2006 Program”). The Executive Compensation Committee established the 2006 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 2006 Program which runs through the end of our fiscal 2007. Awards under the 2006 Program were granted in the form of performance shares pursuant to the terms of our 2003 Plan or Restricted Stock Plan. Performance shares will vest 100% at the end of fiscal

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

NOTE 6. STOCK-BASED COMPENSATION (Continued)

2007 if performance goals are met. Participants in the 2006 Program have the ability to receive up to 150% of the shares originally granted. At the end of the first quarter of fiscal 2007, the number of shares granted was 0.3 million and the maximum number of shares eligible to be received is 0.5 million.

Effective January 24, 2007, the Executive Compensation Committee adopted the 2007 Performance Share Program (“2007 Program”). Similar to the 2006 Program, its purpose is to align key management and senior leadership with stockholder’s interest and to retain key executives. The measurement period for the program is our fiscal 2007 year. All members of Adobe’s executive management and other key senior leaders are participating in the 2007 Program. Awards granted under the 2007 Program were granted in the form of performance shares pursuant to the terms of Restricted Stock Plan. Upon achieving pre-determined attainment goals, shares of stock are granted to the recipient, with 25% vesting immediately, and the remaining 75% vesting evenly on the following three annual anniversary dates of the grant, contingent upon the recipient’s continued service to Adobe. Participants in the 2007 Program have the ability to receive up to 200% of the shares originally granted. At the end of the first quarter of fiscal year 2007, the number of shares granted was 0.3 million and the maximum number of shares eligible to be received is 0.7 million.

Stock-Based Compensation

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 Staff Accounting Bulletin No. 107, “Share-Based Payment,” (“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 zero-coupon yields implied by 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 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.

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

NOTE 6.  STOCK-BASED COMPENSATION (Continued)

The assumptions used to value option grants for the quarters ended March 2, 2007 and March 3, 2006 are as follows:

 

The expected term of employee stock purchase plan shares is the average of the remaining purchase periods under each offering period. The assumptions used to value employee stock purchase rights for the quarters ended March 2, 2007 and March 3, 2006 are as follows:

 

As of March 2, 2007, there was $184.9 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based payments granted to Adobe employees. Additionally, as of March 2, 2007, there was $55.3 million of unamortized stock-based compensation, related to the assumption of Macromedia unvested options, which will be recognized over a weighted average period of 1.15 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.

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

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

NOTE 7.  RESTRUCTURING AND OTHER CHARGES (Continued)

Macromedia Merger Restructuring Charges

A summary of restructuring activities follows as of December 1, 2006 and March 2, 2007:

 

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.

Accrued restructuring charges of $26.7 million at March 2, 2007 includes $7.9 million recorded in accrued restructuring, current and $18.8 million, related to long-term facilities obligations, recorded in accrued restructuring, non-current in the accompanying Condensed Consolidated Balance Sheets. At December 1, 2006, accrued restructuring charges of $31.4 million includes $9.8 million recorded in accrued restructuring, current and $21.6 million, related to long-term facilities obligations, recorded in accrued restructuring, non-current in the accompanying Condensed Consolidated Balance Sheets. We expect to pay these liabilities through fiscal 2011.

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 pay these liabilities through fiscal 2010.

A summary of exit costs follows as of December 1, 2006 and March 2, 2007:

 

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. Accrued restructuring charges as of March 2, 2007 includes $0.2 million recorded in accrued restructuring, current and $0.3 million, related

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

NOTE 7.  RESTRUCTURING AND OTHER CHARGES (Continued)

to long-term facilities obligations, recorded in accrued restructuring, non-current in the accompanying Condensed Consolidated Balance Sheets. As of December 1, 2006, accrued restructuring charges of $0.6 million includes $0.3 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.

NOTE 8.  STOCKHOLDERS’ EQUITY

Stock Repurchase Program—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.

During the first quarter of fiscal 2007 and the first quarter of fiscal 2006, we entered into several structured repurchase agreements with large financial institutions, whereupon we provided the financial institutions with prepayments of $300.0 million and $500.0 million, 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 are no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us.

The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval, and the average VWAP of our stock during the interval less the agreed upon discount. During the first quarter of fiscal 2007, we repurchased 4.8 million shares at an average price of $38.22 through structured repurchase agreements which included prepayments from fiscal 2006. During the first quarter of fiscal 2006, we repurchased 9.6 million shares at an average price of $37.12 through structured repurchase agreements which included prepayments remaining from fiscal 2005.

The prepayments are classified as treasury stock on our balance sheet at the payment date, though only shares physically delivered to us by March 2, 2007 are excluded from the denominator in the computation of earnings per share. All outstanding structured repurchase agreements as of March 2, 2007 will expire on or before September 26, 2007. As of March 2, 2007 and March 3, 2006, approximately $319.3 million and $299.6 million respectively, of up-front payments remained under the agreements.

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

NOTE 9.  COMPREHENSIVE INCOME

Statement of Financial Accounting Standards No. 130 (“SFAS 130”), “Reporting Comprehensive Income,” establishes standards for the reporting and display of comprehensive income and its components in the financial statements. Items of 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 unrealized gains and losses on derivative instruments qualifying as cash flow hedges.

The following table sets forth the components of comprehensive income for the three months ended March 2, 2007 and March 3, 2006:

 

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.

The following table sets forth the computation of basic and diluted net income per share for the three months ended March 2, 2007 and March 3, 2006:

 

For the quarters ended March 2, 2007 and March 3, 2006, options to purchase approximately 8.6 million and 7.3 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $39.70 and $38.16, respectively, were not included in the calculation

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

NOTE 10.  NET INCOME PER SHARE (Continued)

because the effect would have been antidilutive. In addition, excluded from the computation of diluted earnings per share are performance shares.

NOTE 11.  COMMITMENTS AND CONTINGENCIES

Lease Commitments

We occupy three office buildings in San Jose, California where our corporate headquarters are located. We reference these office buildings as the “Almaden Tower” and the “East and West Towers.”

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 approximately $103.0 million. The maximum recourse amount (“residual value guarantee”) under this obligation is $90.8 million. This lease has been subsequently amended and extended effective March 26, 2007. See Note 14 of our Notes to Condensed Consolidated Financial Statements for more detailed information.

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 from 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 will be 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 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 March 2, 2007, 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 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.

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

NOTE 11.  COMMITMENTS AND CONTINGENCIES (Continued)

Guarantees

The lease agreements for our corporate headquarters provide for residual value guarantees. Under FIN 45, 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 Tower 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 March 2, 2007, the unamortized portion of the fair value of the residual value guarantee remaining in other long-term liabilities and prepaid rent was $2.5 million.

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.

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 reduces our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

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

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

NOTE 11.  COMMITMENTS AND CONTINGENCIES (Continued)

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. As of March 2, 2007, we do not believe that a loss is probable or estimable.

On October 13, 2006, a purported shareholder derivative action entitled Steven Staehr v. Bruce R. Chizen, et al was filed in the Superior Court of California for the County of Santa Clara against certain of the Company’s current and former officers and directors, and against Adobe as a nominal defendant. The complaint asserts that stock option grants to executives were priced retroactively by Adobe and were improperly accounted for, and alleges various causes of action based on that assertion. The complaint seeks payment by the defendants to Adobe of damages allegedly suffered by it and disgorgement of profits, as well as injunctive relief. As of March 2, 2007, we do not believe that a loss is probable or estimable.

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.

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.

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

NOTE 12.  CREDIT FACILITY

On February 16, 2007, we entered into a five year, $500.0 million senior syndicated unsecured revolving credit facility providing for loans to us and certain of our foreign subsidiaries. The facility will be used to provide funding for general corporate purposes. Adobe can request two one-year extensions effective on the first and/or second anniversaries of the closing date of the original agreement, subject to a majority consent of the original bank syndicate or any new lenders that may be added. In addition, the amount of the facility may be increased by up to an additional $500.0 million. The existing lenders may elect to increase their commitments or new lenders may be added to the syndicate up to the maximum additional increase of $500.0 million. The facility contains a financial covenant requiring us not to exceed a certain maximum leverage ratio. The facility terminates on February 16, 2012 if no extensions have been requested. Borrowings under the facility bear interest based on a pricing grid tied to the financial covenant. Commitment fees are payable on the facility at rates between 0.05% and 0.15% per year based on the same pricing grid. As of March 2, 2007 we had no outstanding borrowings under this credit facility and were in compliance with all the covenants.

NOTE 13.  INDUSTRY SEGMENTS

We have the following segments: Creative Solutions, Knowledge Worker Solutions, Enterprise and Developer Solutions, Mobile and Device Solutions, and Other, which includes the Print and Classic Publishing and Platform segments. Our Creative Solutions segment focuses on delivering a complete professional line of integrated tools for a full range of creative and developer tasks to an extended set of customers. This segment combines the products of our Creative Professional and Digital Imaging and Video business segments. The Knowledge Worker Solutions segment focuses on the needs of knowledge worker customers, providing essential applications and services to help them share information and collaborate. This segment contains revenue generated by Adobe Acrobat Connect and our Acrobat family of products. Our Enterprise segment provides server-based enterprise interaction solutions that automate people-centric processes. The segment contains revenue generated by our LiveCycle, ColdFusion and Flex lines of products. The Mobile and Device Solutions segment provides solutions that create compelling experiences through rich content, user interfaces, and data services on mobile and non-PC devices such as cellular phones, consumer devices and internet connected hand-held devices. Finally, Other contains several of our products and services which address market opportunities ranging from the diverse publishing needs of technical and business publishing, to our legacy type and OEM printing businesses, to new strategic opportunities such as OEM revenue generated from our desktop technology platform—which includes Adobe Reader and Adobe Flash Player applications.

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

NOTE 13.  INDUSTRY SEGMENTS (Continued)

With the exception of goodwill, we do not identify or allocate our assets by operating segments. See Note 3 for the allocation of goodwill to our reportable segments.

*                    Other segments revenue includes platform revenue of $7.5 million and $6.6 million for the first quarter of fiscal 2007 and 2006 respectively. Costs of revenue related to our platform segment are insignificant for each period. Gross margins for our platform segment are $7.4 million and $6.6 million for the first quarter of fiscal 2007 and 2006, respectively, or 99% and 100% of revenues, respectively. In addition, also included in Other segments is revenue related to our print and publishing businesses.

A reconciliation of the totals reported for the operating segments to the applicable line items in the condensed consolidated financial statements for the quarters ended March 2, 2007 and March 3, 2006 is as follows:

*                    Total operating expenses comprise research and development, sales and marketing, general and administrative, restructuring and other charges, and amortization of purchased intangibles.

NOTE 14.  SUBSEQUENT EVENT

Renewal of Almaden Tower Lease

On March 26, 2007, the Almaden Tower lease was amended and extended to March 26, 2012, with a renewal option for an additional five years solely at Adobe’s election. This lease will continue to qualify for

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

NOTE 14.  SUBSEQUENT EVENT (Continued)

operating lease treatment under Statement of Financial Accounting Standards No. 13, “Accounting for Leases”, and as such, the buildings and the related obligations will not be included on our consolidated balance sheet. However, as part of the lease extension, we purchased a portion of the lease receivable of the lessor for $80.4 million, which will be recorded as an investment in lease receivable on our consolidated balance sheet for the quarter ended June 1, 2007, similar in structure to the lease for the East and West Towers. This purchase may be credited against the residual value guarantee if we purchase the properties or will be repaid from the sale proceeds if the properties are sold to third parties. Under the agreement, we have the option to purchase the buildings at any time during the lease term for approximately $103.6 million. The maximum recourse amount (“residual value guarantee”) under this obligation is $89.4 million.

In addition, under FIN 45 “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, we will record $3.0 million in other long-term liabilities, equal to the fair value of the residual value guarantee, with the offsetting entry recorded to prepaid rent in other assets. This balance will be amortized to the income statement over the life of the lease.

Structured Stock Repurchase Agreements

In April 2007, we entered into additional structured stock repurchase agreements with large financial institutions whereupon we provided the financial institutions with pre-payments of $300.0 million. The $300.0 million will be classified as treasury stock on our balance sheet. See Note 8 of our Notes to Condensed Consolidated Financial Statements for further information regarding our structured stock repurchase agreements.

New Stock Repurchase Program

In April 2007, we announced that our Board of Directors authorized a new stock repurchase program. Under the new program, we are authorized to repurchase in aggregate up to 20 million shares of our common stock and is not subject to expiration. This program is in addition to our existing stock repurchase program to offset dilution from employee stock programs.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion (presented in millions, except share and per share amounts, and is unaudited) should be read in conjunction with the condensed consolidated financial statements and notes thereto.

In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements, including statements regarding product plans, future growth and market opportunities, which involve risks and uncertainties that could cause actual results to differ materially. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section titled “Risk Factors” in Part II, Item 1A. You should carefully review the risks described herein and in other documents we file from time to time with the Securities and Exchange Commission, including the Annual Report on Form 10-K/A for fiscal 2006  and the other Quarterly Reports on Form 10-Q to be filed by us in fiscal 2007. When used in this report, the words “expects,” “could,” “would”, “may,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “targets,” “estimates,” “looks for,” “looks to,” and similar expressions, as well as statements regarding our focus for the future, are generally intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. We undertake no obligation to publicly release any revisions to the forward-looking statements or reflect events or circumstances after the date of this document.

BUSINESS OVERVIEW

Founded in 1982, Adobe Systems Incorporated is one of the largest and most diversified software companies in the world. We offer a line of creative, business and mobile software and services used by high-end consumers, creative professionals, designers, knowledge workers, OEM partners, developers and enterprises for creating, managing, delivering and engaging with compelling content and experiences across multiple operating systems, devices and media. We distribute our products through a network of distributors and dealers, value-added resellers (“VARs”), systems integrators, independent software vendors (“ISVs”) and OEMs; direct to end users; and through our own Web site at www.adobe.com. We also license our technology to major hardware manufacturers, software developers and service providers and we offer integrated software solutions to businesses of all sizes. We have operations in the Americas; Europe, Middle East, and Africa (“EMEA”); and Asia. Our software runs on Microsoft Windows, Apple OS, Linux, UNIX and various non-personal computer platforms, depending on the product.

We maintain executive offices and principal facilities at 345 Park Avenue, San Jose, California 95110-2704. Our telephone number is 408-536-6000. We maintain a Web site at www.adobe.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC Web site at www.sec.gov.

OPERATIONS OVERVIEW

During the first quarter of fiscal 2007, we continued to focus on driving revenue growth and increasing market share of our products through the continued delivery of comprehensive software solutions that meet the evolving needs of our customers.

In our Creative Solutions business, revenue declined sequentially from our fourth quarter as we expected. We attributed this decline due to lower demand as some of our customers wait for a new major product launch to occur in our second quarter of fiscal 2007, which we previously announced publicly. To spur continued demand, we released an updated version of our Creative Suite 2 Premium product, which contained the new Acrobat 8 Professional software.

In our Knowledge Worker Solutions business, following the launch of Acrobat 8 in our fourth quarter of fiscal 2006, we achieved the second highest quarterly revenue ever for our Acrobat family of products in our first quarter of fiscal 2007. Helping drive this success was ongoing adoption by users in enterprises,

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governments, and vertical markets such as architecture, engineering and construction. Acrobat revenue was somewhat negatively impacted in the quarter due to the issues with our new license management technology in the product, which were resolved later in the quarter.

Our Enterprise and Developer Solutions business achieved 13% year-over-year growth as we continued to focus on delivering innovative products and solutions for our customers. Our Mobile and Device business achieved strong year-over-year and quarter-over-quarter growth due to the ongoing success we have had targeting mobile operators, handset manufacturers, and consumer electronic device manufactures with our Flash Lite and FlashCast technologies. Other segment revenue increased primarily due to higher revenue from the monetization of our free download client software.

We continue to focus on delivering innovative products and solutions for our customers. Our success could be limited by several factors, including the timely release of new products, continued market acceptance of our products, the introduction of new products by existing or new competitors and unfavorable exchange rate fluctuations. For a further discussion of these and other risk factors, see Part II, Item IA, “Risk Factors.”

CRITICAL ACCOUNTING ESTIMATES

In preparing our consolidated financial statements, we make assumptions, judgments and estimates that can have a significant impact on amounts reported in our consolidated financial statements. We base our assumptions, judgments and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. We believe that the assumptions, judgments and estimates involved in the accounting for revenue recognition, stock-based compensation, goodwill and income taxes have the greatest potential impact on our consolidated financial statements. These areas are key components of our results of operations and are based on complex rules which require us to make judgments and estimates, so we consider these to be our significant accounting policies. Historically, our assumptions, judgments and estimates relative to our significant accounting policies have not differed materially from actual results.

There have been no significant changes in our critical accounting estimates during the three months ended March 2, 2007 as compared to the critical accounting estimates disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K/A for the year ended December 1, 2006.

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RESULTS OF OPERATIONS

Revenue

 

As described in Note 13 of our Notes to Condensed Consolidated Financial Statements, we have the following segments: Creative Solutions, Knowledge Worker Solutions, Enterprise and Developer Solutions, Mobile and Device Solutions, and Other, which includes the Print and Classic Publishing and Platform segments.

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 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, is recognized ratably over the term of the arrangement.

Segment Information

*                    Other segments revenue includes Platform revenue of $7.5 million and $6.6 million for the first quarter of fiscal 2007 and 2006 respectively, or 1% and 1% of revenues, respectively. Also included in Other segments is revenue related to our Print and Publishing businesses.

Revenue from our Creative Solutions segment decreased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to weaker sales from our Adobe Creative Suites product in anticipation of our release of CS3. Offsetting this decline was strength with our Flash Media Server and Flash Video Streaming Service solutions which customers use to offer Flash Video on their websites.

Revenue from our Knowledge Worker Solutions segment increased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to the continued success of Acrobat 8.0

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which was launched at the end of the fourth quarter of fiscal 2006, followed by launches in additional languages during the first quarter of fiscal 2007. There were no significant decreases in revenues from products in this segment during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006.

Revenue from our Enterprise and Developer Solutions segment increased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 partially due to an increase in revenues from our Flex products due to increased licensing, services and support.

Revenue from our Mobile and Device Solutions segment increased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to the continued growth of its products, including Flash Lite and FlashCast.

Revenue from our Other segments increased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to stronger revenue related to our PostScript licensing and also due to increased licensing related to our Flash Player and Shockwave during the quarter. In addition, Other segment revenue increased primarily due to higher revenue from the monetization of our free download client software Revenue from PostScript licensing has generally declined over the last few years and we do not expect to sustain the growth achieved during this quarter.

Geographical Information

*                    Percentage is not meaningful.

Revenues in the Americas decreased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 primarily due to the decline in revenues from our Creative Solutions products but was slightly offset by an increase in revenues from our Other segment products.

Revenues in EMEA increased during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 due to increases of approximately $13.5 million due to the strengthening of the dollar against the euro. This increase was partially offset by a decline in revenues from our Creative Solutions products.

Revenues in Asia increased slightly during the first quarter of fiscal 2007 as compared to the first quarter of fiscal 2006 due to the strength of our Mobile and Device Solutions products and Other products. This increase was partially offset by a decline in revenues from our Creative Solutions products. Revenues in Asia were not materially impacted by changes in the yen.

Inventory Information

At the end of the first quarter of fiscal 2007 our distributor inventory position was within our global inventory policy which allows up to an estimated 4.5 weeks of anticipated product supply at our distributors.

With regard to our product backlog, our experience is that the actual amount of backlog at any particular time may not be a meaningful indicator of future business prospects. For example, prior to the finalization and release of new products, we may have significant levels of orders for new product releases. Our backlog of unfulfilled orders at the end of the first quarter of fiscal 2007, other than those associated

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with new product releases, those pending credit review and those not shipped due to the application of our global distributor inventory policy, was less than 1% of first quarter fiscal 2007 revenue. The comparable backlog at the end of fiscal 2006 was approximately 2% of fourth quarter fiscal 2006 revenue.

Cost of Revenue

 

Cost of product revenue includes product packaging, third-party royalties, excess and obsolete inventory, amortization related to localization costs and acquired technologies and the costs associated with the manufacturing of our products.

Cost of product revenue fluctuated due to the following:

 

Cost of services and support revenue is composed primarily of employee-related costs and related costs incurred to provide consulting services, training and product support.

Cost of services and support revenue increased in the first quarter of fiscal 2007 as compared to the same period in the prior fiscal year primarily due to increases in services and support activities.

Operating Expenses

*                    Percentage is less than 1%.

Research and development expenses consist primarily of salary and benefit expenses for software developers, contracted development efforts, related facilities costs and expenses associated with computer equipment used in software development.

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Research and development expenses fluctuated due to the following:

*                    Percentage is less than 1%.

We believe that investments in research and development, including the recruiting and hiring of software developers, are critical to remain competitive in the marketplace and are directly related to continued timely development of new and enhanced products. We will continue to focus on long-term opportunities available in our end markets and make significant investments in the development of our desktop application and server-based software products.

*                    Percentage is less than 1%.

Sales and marketing expenses primarily include salary and benefit expenses, sales commissions, travel expenses and related facilities costs for our sales, marketing, customer support, order management and global supply chain management personnel. Sales and marketing expenses also include the costs of programs aimed at increasing revenue, such as advertising, trade shows, public relations and other market development programs.

Sales and marketing expenses fluctuated due to the following:

*                    Percentage is less than 1%.

 

General and administrative expenses consist primarily of compensation and benefit expenses, travel expenses, and related facilities costs for our finance, facilities, human resources, legal, information services

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and executive personnel. General and administrative expenses also include outside legal and accounting fees, provision for bad debts, expenses associated with computer equipment and software used in the administration of the business, charitable contributions and various forms of insurance.

General and administrative expenses fluctuated due to the following:

 

Restructuring and Other Charges

*                    Percentage is not meaningful.

In the first quarter of fiscal 2006, pursuant to Board of Directors’ approval, we implemented a restructuring plan to eliminate 313 positions, held by Adobe employees worldwide and which impacted all functional areas. The reduction in force was completed in fiscal 2006. The restructuring plan, also includes costs related to the world-wide consolidation of facilities, the cancellation of certain contracts and the write-off of fixed assets located at facilities that will be vacated.

Amortization of Purchased Intangibles

 

As a result of acquiring Macromedia, we acquired purchased intangibles that which will be amortized over their estimated useful lives of two to four years. In addition, during the first quarter of fiscal 2007 we acquired $2.0 million of purchased intangibles which will be amortized over their estimated useful lives.

Non-operating Income

*                    Percentage is not meaningful.

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