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 June 1, 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)

 

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 June 29, 2007 was 588,437,512.

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 June 1, 2007 and December 1, 2006		3
		Condensed Consolidated Statements of Income Three and Six Months Ended June 1, 2007 and June 2, 2006		4
		Condensed Consolidated Statements of Cash Flows Six Months Ended June 1, 2007 and June 2, 2006		5
		Notes to Condensed Consolidated Financial Statements		6
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		23
Item 3.		Quantitative and Qualitative Disclosures about Market Risk		35
Item 4.		Controls and Procedures		35
PART II—OTHER INFORMATION
Item 1.		Legal Proceedings		36
Item 1A.		Risk Factors		36
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		44
Item 4.		Submission of Matters to a Vote of Security Holders		45
Item 5.		Other Information		45
Item 6.		Exhibits		47
Signature				53
Summary of Trademarks				54

 

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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

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

There have been no significant changes in our significant accounting policies during the three and six months ended June 1, 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 for the six months ended June 2, 2006 as reported in the Consolidated Statements of Cash Flows have been revised. Specifically, there were revisions and reclassifications totaling ($1.6) million to operating activities, $0.2 million to investing activities and $1.4 million to financing activities. These revisions and reclassifications related to the following:

·       Changes in 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 (the “FASB”) statement defined below, there have been no significant changes in recent accounting pronouncements during the six months ended June 1, 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 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 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.

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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)

In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 07-1, “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies” (“SOP 07-1”). SOP 07-1 defines investment companies for purposes of applying the related AICPA Audit and Accounting Guide. SOP 07-1 provides guidance on whether an investment company’s parent or equity-method investor should retain investment-company accounting in its financial statements. SOP 07-1 is effective for the company beginning in the first quarter of fiscal year 2009, although earlier adoption is permitted. The company is currently evaluating the impact that SOP 07-1 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 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 billion in goodwill.

During the six months ended June 1, 2007, we completed two acquisitions for cash consideration of approximately $70 million. These acquisitions were not material to our consolidated balance sheet and results of operations. The purchase accounting estimates applied in the acquisition that occurred in the second quarter of fiscal 2007 (involving net cash consideration of $64.3 million) are preliminary and subject to further adjustments in subsequent reporting periods.

NOTE 3. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

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

*                    Changes in goodwill in our Other segment relate primarily to our Print and Classic Publishing segment.

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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)

Shown above in the column labeled Other is an adjustment to goodwill for tax credits of $35 million available to the company from the Macromedia acquisition and the realization of tax benefits for deductions resulting from the exercise of stock options and disqualifying dispositions of vested options assumed. Additionally, there are immaterial revisions to the valuation of Macromedia assumed options which reduced goodwill and additional paid-in-capital at June 1, 2007.

Amortization expense related to purchased and other intangible assets was $65.0 million and $113.7 million for the three and six months ended June 1, 2007, respectively. Comparatively, amortization expense was $55.0 million and $112.1 for the three and six months ended June 2, 2006, respectively. Of these amounts, $47.5 million and $78.5 million are included in cost of sales for the three and six months ended June 1, 2007, respectively and $37.6 million and $77.6 million are included in cost of sales for the three and six months June 2, 2006, respectively. Purchased and other intangible assets, subject to amortization were as follows as of June 1, 2007:

 

During the second quarter of fiscal 2007, we entered into certain technology licensing arrangements for approximately $46 million. An estimated $29.8 million of this cost is related to future licensing rights and has been capitalized and recorded as purchased technology. The remainder of the cost was charged to cost of sales in the second quarter of fiscal 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)

Purchased and other intangible assets are amortized over their estimated useful lives up to 15 years. As of June 1, 2007, we expect amortization expense in future periods to be as shown below:

 

NOTE 4. OTHER ASSETS

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

 

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

NOTE 5. TRADE AND OTHER PAYABLES AND ACCRUED EXPENSES (Continued)

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

 

NOTE 6. EMPLOYEE BENEFIT PLANS

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 (i) 2003 Equity Incentive Plan (the “2003 Plan”), under which options can be granted to all employees, including executive officers, and outside consultants and (ii) 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. 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 second quarter of fiscal 2007, the number of shares outstanding was 58.1 million.

The total intrinsic value of options exercised during the six months ended June 1, 2007 was $228.7 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 (“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 and/or performance awards to officers and key employees under our Amended 1994 Performance and Restricted Stock Plan (the “Restricted Stock Plan”). Restricted stock issued under the Restricted Stock Plan generally vest annually over four years.

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

NOTE 6. EMPLOYEE BENEFIT PLANS (Continued)

Restricted stock awards are considered outstanding at the time of grant, as the stock award holders are entitled to dividends and voting rights. At the end of the second quarter of fiscal 2007, the number of shares granted but still unvested 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 second 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, 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 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 second 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 (the “2007 Program”). Similar to the 2006 Program, the 2007 program’s purpose is to align key management and senior leadership with stockholder’s interest and to retain key employees. 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. If pre-determined attainment goals are met, shares of stock will be granted to the recipient, with 25% vesting upon achievement of the attainment goals, 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 second 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 0.6 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

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

NOTE 6. EMPLOYEE BENEFIT PLANS (Continued)

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”. 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.

The assumptions used to value option grants for the three and six months ended June 1, 2007 and June 2, 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 three and six months ended June 1, 2007 and June 2, 2006 are as follows:

 

As of June 1, 2007, there was $167.1 million of unrecognized compensation cost, which will be recognized over a weighted average period of 3.6 years adjusted for estimated forfeitures, related to non-vested stock-based payments granted to Adobe employees. Additionally, as of June 1, 2007, there was $48.8 million of unamortized stock-based compensation, related to the assumption of Macromedia unvested options, which will be recognized over a weighted average period of 1.04 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.

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

NOTE 6. EMPLOYEE BENEFIT PLANS (Continued)

Deferred Compensation Plan

On September 21, 2006, the Board of Directors approved the Adobe Systems Incorporated Deferred Compensation Plan, effective December 2, 2006 (the “Deferred Compensation Plan”). The Deferred Compensation Plan is an unfunded, non-qualified, deferred compensation arrangement under which certain executives and members of the Board of Directors are able to defer a portion of their annual compensation. Participants may elect to contribute up to 75% of their base salary and 100% of other specified compensation, including commissions, bonus, performance-based restricted stock units, and directors’ fees. Participants will be able to elect the payment of benefits to begin on a specified date at least three years after the end of the plan year in which the election is made in the form of a lump sum or annual installments over five to fifteen years. Upon termination of a participant’s employment with Adobe, such participant will receive a distribution in the form of a lump sum payment. All distributions will be made in cash, except that deferred performance share units will be settled in stock. As of June 1, 2007, the invested amounts under the Deferred Compensation Plan total $1.2 million and are recorded as long-term other assets on the Company’s balance sheet. As of June 1, 2007, we recorded $1.2 million as a long-term liability to recognize undistributed deferred compensation due to employees.

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.

Macromedia Merger Restructuring Charges

A summary of restructuring activities follows as of December 1, 2006 and June 1, 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.

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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)

Accrued restructuring charges of $23.4 million at June 1, 2007 includes $6.4 million recorded in accrued restructuring, current and $17.0 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 (i) termination benefits for former Adobe employees whose positions were eliminated, (ii) the closure of Adobe facilities and (iii) the cancellation of certain contracts held by Adobe.

Accrued restructuring charges as of June 1, 2007 includes $0.2 million recorded in accrued restructuring, current in the accompanying Condensed Consolidated Balance Sheets related primarily to the cost of closing redundant facilities. 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 I

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 six months ended June 1, 2007 and June 2, 2006, we entered into various structured repurchase agreements with large financial institutions, where upon we provided the financial institutions with prepayments of $600 million and $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 expected 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

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

NOTE 8. STOCKHOLDERS’ EQUITY (Continued)

average VWAP of our stock during the interval less the agreed upon discount. During the first half of fiscal 2007, we repurchased 10.7 million shares at an average price of $39.00 through structured repurchase agreements which included prepayments from fiscal 2006. During the first half of fiscal 2006, we repurchased 1.7 million shares at an average price of $36.04 through open market repurchases and 22.5 million shares at an average price of $36.02 through these structured repurchase agreements which included prepayments 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 June 1, 2007 are excluded from the denominator in the computation of earnings per share. All outstanding structured repurchase agreements as of June 1, 2007 will expire on or before December 21, 2007. As of June 1, 2007 and June 2, 2006, approximately $386.9 million and $344.1 million, respectively, of up-front payments remained under the agreements.

Stock Repurchase Program II

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 the program is not subject to expiration. This program is in addition to our existing stock repurchase program to offset dilution from employee stock programs. As of June 1, 2007, no shares have been repurchased under this program. See Note 14 for discussion of the subsequent event related to the stock repurchase program II.

NOTE 9. COMPREHENSIVE INCOME

FASB 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 unrealized 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 six months ended June 1, 2007 and June 2, 2006:

 

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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

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 and six months ended June 1, 2007 and June 2, 2006:

 

For the three and six months ended June 1, 2007 options to purchase approximately 11.9 million and 10 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $41.80 and $40.77, respectively, were not included in the calculation because the effect would have been antidilutive. Comparatively, for the three and six months ended June 2, 2006, options to purchase approximately 14.7 million and 13.7 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $34.96 and $36.54, respectively, were not included in the calculation because the effect would have been antidilutive.

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 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 our election. In March 2007, the Almaden Tower lease was extended for five years, with a renewal option for an additional five years solely at our election. As part of the lease extensions, we purchased the lease receivable from the lessor of the East and West Towers for $126.8 million and a portion of the lease receivable from the lessor of the Almaden Tower for $80.4 million, both of which are recorded as investments in lease receivables 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 and the agreement for the Almaden Tower, we have

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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)

the option to purchase the buildings at any time during the lease term for approximately $143.2 million and $103.6 million, respectively. The residual value guarantees under the East and West Towers and the Almaden Tower obligations are $126.8 million and $89.4 million, respectively.

These two leases are both subject to standard covenants including certain financial ratios that are reported to the lessors quarterly. As of June 1, 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 FASB 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, 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 residual value guarantee amount.

Guarantees

The lease agreements for our corporate headquarters provide for residual value guarantees as noted above. Under FASB Interpretation No. 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 $5.2 million and $3 million in liabilities, related to the extended East and West Towers and Almaden Tower leases, respectively, upon entering into the leases. These liabilities are 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 leases. As of June 1, 2007, the unamortized portion of the fair value of the residual value guarantees, for both leases, remaining in other long-term liabilities and prepaid rent was $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

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(In thousands, except per share data)
(Unaudited)

NOTE 11. COMMITMENTS AND CONTINGENCIES (Continued)

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.

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.” In May 2007, we resolved this matter without any material effect on our financial statements.

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 June 1, 2007, we do not believe that a loss is probable or estimable.

In connection with our anti-piracy efforts, conducted both internally and through organizations such as the Business Software Alliance, from time to time we undertake litigation against alleged copyright infringers. Such lawsuits may lead to counter-claims alleging improper use of litigation or violation of other local laws. We believe we have valid defenses with respect to such counter-claims; however, it is possible that our consolidated financial position, cash flows or results of operations could be affected in any particular period by the resolution of one or more of these counter-claims.

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(In thousands, except per share data)
(Unaudited)

NOTE 11. COMMITMENTS AND CONTINGENCIES (Continued)

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. CREDIT FACILITY

In February 2007, we entered into a five year, $500 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 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 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 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 June 1, 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 businesses. During the second quarter of fiscal 2007, we launched the English versions of our new Creative Suite 3 family of products. 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

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

NOTE 13. INDUSTRY SEGMENTS (Continued)

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 segment which includes Adobe Reader and Adobe Flash Player applications.

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.

 

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

NOTE 13. INDUSTRY SEGMENTS (Continued)

*                    Other includes revenue related to the Print and Classic Publishing segment of $48.9 million and $105 million for the three and six months ended June 1, 2007, respectively, or 7% and 8%, respectively, of revenues. For the three and six months ended June 2, 2006, Other includes revenue related to the Print and Classic Publishing segment of $53.4 million and $100.2 million, respectively, or 8% of revenues. Also included in Other segment revenue, in fiscal 2007 and 2006, is revenue related to our Platform segment. Costs of revenue related to our Print and Classic Publishing segment are $6 million and $13.8 million for the three and six months ended June 1, 2007 and $2.4 million and $12.5 million for the three and six months ended June 2, 2006. Gross margins for our Print and Classic Publishing segment are $42.9 million and $91.2 million for the three and six months ended June 1, 2007, respectively, or 88% and 87% of revenues, respectively. Gross margins for our Print and Classic Publishing segment are $51 million and $87.8 million for the three and six months ended June 2, 2006, respectively, or 95% and 88% of revenues, respectively.

A reconciliation of the totals reported for the operating segments to the applicable line items in the condensed consolidated financial statements for the three and six month periods ended June 1, 2007 and June 2, 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.

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

NOTE 14. SUBSEQUENT EVENT

Structured Stock Repurchase Agreements

As part of the stock repurchase program II, we entered into additional structured stock repurchase agreements in June 2007 with large financial institutions whereupon we provided the financial institutions with prepayments of $850 million. The $850 million will be classified as treasury stock on our balance sheet. See Note 8 for further information regarding our structured stock repurchase agreements.

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