Edgar Filing: ADOBE SYSTEMS INC

form_10q.htm

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 August 29, 2008

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

For the transition period from to

Commission File Number: 0-15175

ADOBE SYSTEMS INCORPORATED

(Exact name of registrant as specified in its charter)

_________________________

Delaware

(State or other jurisdiction of

incorporation or organization)

77-0019522

(I.R.S. Employer

Identification No.)

345 Park Avenue, San Jose, California 95110-2704

(Address of principal executive offices and zip code)

(408) 536-6000

(Registrant’s telephone number, including area code)

_________________________

Indicate by 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, a non-accelerated filer or a smaller reporting company (as defined in Rule 12b-2 of the Act).

Large accelerated filer x

Accelerated filer o

Non-accelerated filer o

(Do not check if a smaller

reporting company)

Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o No x

The number of shares outstanding of the registrant’s common stock as of September 26, 2008 was 530,956,085.

ADOBE SYSTEMS INCORPORATED

FORM 10-Q

TABLE OF CONTENTS

		Page No.
PART I—FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements:		3
	Condensed Consolidated Balance Sheets August 29, 2008 and November 30, 2007		3
	Condensed Consolidated Statements of Income Three and Nine Months Ended August 29, 2008 and August 31, 2007		4
	Condensed Consolidated Statements of Cash Flows Nine Months Ended August 29, 2008 and August 31, 2007		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		35
Item 1A.	Risk Factors		35
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		43
Item 5.	Other Information		44
Item 6.	Exhibits		44
Signature			51
Summary of Trademarks			52

Table of Contents

PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

	August 29, 2008			November 30, 2007
ASSETS
Current assets:
Cash and cash equivalents	$	1,134,263		$	946,422
Short-term investments		866,641			1,047,432
Trade receivables, net of allowances for doubtful accounts of $6,264 and $4,398, respectively		327,970			318,145
Other receivables		33,687			44,666
Deferred income taxes		94,500			171,472
Prepaid expenses and other assets		60,059			44,714
Total current assets		2,517,120			2,572,851
Property and equipment, net		317,071			289,758
Goodwill		2,134,032			2,148,102
Purchased and other intangibles, net		246,401			367,644
Investment in lease receivable		207,239			207,239
Other assets		216,887			128,085
Total assets	$	5,638,750		$	5,713,679

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade and other payables	$	56,254		$	66,867
Accrued expenses		356,408			383,436
Accrued restructuring		6,862			3,731
Income taxes payable		37,546			215,058
Deferred revenue		204,593			183,318
Total current liabilities		661,663			852,410
Long-term liabilities:
Debt		350,000			—
Deferred revenue		27,838			25,950
Accrued restructuring		8,096			13,987
Income taxes payable		99,636			—
Deferred income taxes		96,827			148,943
Other liabilities		23,248			22,407
Total liabilities		1,267,308			1,063,697
Stockholders’ equity:
Preferred stock, $0.0001 par value; 2,000 shares authorized, none issued		—			—
Common stock, $0.0001 par value; 900,000 shares authorized; 600,834 shares issued; 531,475 and 571,409 shares outstanding, respectively		61			61
Additional paid-in-capital		2,369,689			2,340,969
Retained earnings		4,667,489			4,041,592
Accumulated other comprehensive income		23,439			27,948
Treasury stock, at cost (69,359 and 29,425 shares, respectively), net of reissuances		(2,689,236	)		(1,760,588	)
Total stockholders’ equity		4,371,442			4,649,982
Total liabilities and stockholders’ equity	$	5,638,750		$	5,713,679

See accompanying Notes to Condensed Consolidated Financial Statements.

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ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

	Three Months						Nine Months
	August 29, 2008			August 31, 2007			August 29, 2008			August 31, 2007
Revenue:
Products	$	838,813		$	813,382		$	2,532,076		$	2,147,149
Services and support		48,444			38,304			132,512			99,521
Total revenue		887,257			851,686			2,664,588			2,246,670
Total cost of revenue:
Products		84,623			69,002			202,657			193,532
Services and support		26,228			23,619			73,535			62,566
Total cost of revenue		110,851			92,621			276,192			256,098
Gross profit		776,406			759,065			2,388,396			1,990,572
Operating expenses:
Research and development		170,124			163,217			508,909			450,395
Sales and marketing		271,439			251,243			813,399			702,323
General and administrative		97,156			71,132			257,163			201,004
Restructuring and other charges		1,194			555			2,625			555
Amortization of purchased intangibles and incomplete technology		17,024			17,893			51,222			54,542
Total operating expenses		556,937			504,040			1,633,318			1,408,819
Operating income		219,469			255,025			755,078			581,753
Non-operating income (expense):
Interest and other income, net		9,338			22,733			34,778			65,866
Interest expense		(2,390	)		(69	)		(8,027	)		(175	)
Investment gains (loss)		2,097			(694	)		20,335			9,069
Total non-operating income, net		9,045			21,970			47,086			74,760
Income before income taxes		228,514			276,995			802,164			656,513
Provision for income taxes		36,906			71,752			176,267			154,914
Net income	$	191,608		$	205,243		$	625,897		$	501,599
Basic net income per share	$	0.36		$	0.35		$	1.15		$	0.85
Shares used in computing basic net income per share		531,060			583,670			542,624			587,141
Diluted net income per share	$	0.35		$	0.34		$	1.13		$	0. 83
Shares used in computing diluted net income per share		541,311			597,334			552,739			602,263

See accompanying Notes to Condensed Consolidated Financial Statements.

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ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended
	August 29, 2008			August 31, 2007
Cash flows from operating activities:
Net income	$	625,897		$	501,599
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion		200,537			237,274
Stock-based compensation		137,613			110,196
Provision for estimated returns		93,683			132,871
Tax benefit from employee stock option plans		83,740			75,878
Deferred income taxes		34,336			(20,405	)
Other non-cash items		6,764			(1,028	)
Gains on sales of investments, net of impairments		(9,690	)		(10,834	)
Excess tax benefits from stock-based compensation		(23,635	)		(54,396	)
Changes in operating assets and liabilities, net of acquired assets and liabilities:
Receivables		(96,399	)		(37,968	)
Prepaid expenses and other current assets		(6,202	)		(16,135	)
Trade and other payables		(10,613	)		9,052
Accrued expenses		(36,957	)		34,919
Accrued restructuring		(5,418	)		(10,547	)
Income taxes payable		(73,957	)		64,746
Deferred revenue		23,163			25,971
Net cash provided by operating activities		942,862			1,041,193
Cash flows from investing activities:
Purchases of short-term investments		(840,782	)		(1,755,079	)
Maturities of short-term investments		520,784			335,895
Sales of short-term investments		486,904			1,531,651
Purchases of property and equipment		(88,481	)		(103,944	)
Purchases of long-term investments and other assets		(102,029	)		(85,173	)
Investment in lease receivable		—			(80,439	)
Cash received from acquisitions		—			1,507
Cash paid for acquisitions		—			(68,237	)
Issuance costs for credit facility		—			(838	)
Proceeds from sale of equity securities		18,085			11,310
Net cash used for investing activities		(5,519	)		(213,347	)
Cash flows from financing activities:
Purchases of treasury stock		(1,422,735	)		(1,451,525	)
Proceeds from issuance of treasury stock		301,454			354,546
Excess tax benefits from stock-based compensation		23,635			54,396
Proceeds from borrowings under credit facility		450,000			—
Repayments of borrowings under credit facility		(100,000	)		—
Net cash used for financing activities		(747,646	)		(1,042,583	)
Effect of foreign currency exchange rates on cash and cash equivalents		(1,856	)		1,520
Net increase (decrease) in cash and cash equivalents		187,841			(213,217	)
Cash and cash equivalents at beginning of period		946,422			772,500
Cash and cash equivalents at end of period	$	1,134,263		$	559,283
Supplemental disclosures:
Cash paid for income taxes, net of refunds	$	129,320		$	38,434

See accompanying Notes to Condensed Consolidated Financial Statements.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)

(Unaudited)

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

We have prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Pursuant to these rules and regulations, we have condensed or omitted certain information and footnote disclosures we normally include in our annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In management’s opinion, we have made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present our financial position, results of operations and cash flows. Our interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in our Annual Report on Form 10-K for the fiscal year ended November 30, 2007 on file with the SEC.

There have been no material changes in our significant accounting policies, except for the adoption of the Financial Accounting Standards Board (“FASB”) Financial Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”, on December 1, 2007 as compared to the significant accounting policies described in our Annual Report on Form 10-K for the fiscal year ended November 30, 2007.

Reclassification

Certain prior year amounts have been reclassified to conform to current year presentation in the condensed consolidated balance sheets. Specifically, there was a reclassification totaling $35.0 million from purchased intangibles to long-term and short-term other assets. See Notes 3 and 4 for additional information regarding this reclassification.

Recent Accounting Pronouncements

With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the nine months ended August 29, 2008, as compared to the recent accounting pronouncements described in our Annual Report on Form 10-K for the fiscal year ended November 30, 2007, that are of significance, or potential significance, to us.

In September 2008, the FASB issued FASB Staff Position (“FSP”) No. 133-1 and FIN 45-4 (“FSP FAS 133-1 and FIN 45-4”), “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 45; and Clarification of the Effective Date of FASB Statement No. 161”. FSP FAS 133-1 and FIN 45-4 amends FASB Statement No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities”, to require disclosures by sellers of credit derivatives, including credit derivatives embedded in hybrid instruments. FSP FAS 133-1 and FIN 45-4 also amend FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others”, to require additional disclosure about the current status of the payment/performance risk of a guarantee. The provisions of the FSP that amend SFAS 133 and FIN 45 are effective for reporting periods ending after November 15, 2008. FSP FAS 133-1 and FIN 45-4 also clarifies the effective date in FASB Statement No. 161 (“SFAS 161”), “Disclosures about Derivative Instruments and Hedging Activities”. Disclosures required by SFAS 161 are effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Because FSP FAS 133-1 and FIN 45-4 only require additional disclosures, the adoption will not impact our consolidated financial position, results of operations or cash flows.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

In April 2008, the FASB issued FSP No. 142-3 (“FSP 142-3”), “Determination of the Useful Life of Intangible Assets”. FSP 142-3 amends the factors an entity should consider in developing renewal or extension assumptions used in determining the useful life of recognized intangible assets under FASB Statement No. 142, “Goodwill and Other Intangible Assets”. This new guidance applies prospectively to intangible assets that are acquired individually or with a group of other assets in business combinations and asset acquisitions. FSP 142-3 is effective for financial statements issued for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. Since this guidance will be applied prospectively, on adoption, there will be no impact to our current consolidated financial statements.

In March 2008, the FASB issued SFAS 161 which requires companies with derivative instruments to disclose information that should enable financial-statement users to understand how and why a company uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133, and how derivative instruments and related hedged items affect a company’s financial position, financial performance and cash flows. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Because SFAS 161 only requires additional disclosure, the adoption will not impact our consolidated financial position, results of operations or cash flows.

In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 07-1 (“SOP 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 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 would have been effective beginning in the first quarter of fiscal 2009; however, in February 2008, the FASB issued FSP SOP 07-1-1 which indefinitely delayed the effective date of SOP 07-1.

In February 2007, the FASB issued FASB Statement No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities”. Under SFAS 159, companies may elect 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 and disclosed. SFAS 159 was effective for us beginning in the first quarter of fiscal 2008. We currently do not have any instruments for which we have elected the fair value option under SFAS 159. Therefore, the adoption of SFAS 159 has not impacted our consolidated financial position, results of operations or cash flows.

In September 2006, the FASB issued FASB Statement No. 157 (“SFAS 157”), “Fair Value Measurements”, which defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements and is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB FSP 157-2 which delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. These nonfinancial items include assets and liabilities such as reporting units measured at fair value in a goodwill impairment test and nonfinancial assets acquired and liabilities assumed in a business combination. Effective December 1, 2007, we adopted SFAS 157 for financial assets and liabilities recognized at fair value on a recurring basis. The partial adoption of SFAS 157 for financial assets and liabilities did not have a material impact on our consolidated financial position, results of operations or cash flows. See Note 2 for information and related disclosures regarding our fair value measurements.

In July 2006, the FASB issued FIN 48 which clarifies the accounting for uncertainty in income taxes by prescribing the recognition threshold a tax position is required to meet before being recognized in the financial statements. It also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Additionally, in May 2007, the FASB published FSP No. FIN 48-1 (“FSP FIN 48-1”), “Definition of Settlement in FASB Interpretation No. 48”. FSP FIN 48-1 is an amendment to FIN 48. It clarifies how an enterprise should determine whether a tax position is effectively settled for the purpose of recognizing previously unrecognized tax benefits. We adopted both FIN 48 and FSP FIN 48-1 on December 1, 2007. The adoption of FIN 48 and FSP FIN 48-1 resulted in an increase to both assets and liabilities in our condensed consolidated balance sheet as of the beginning of fiscal 2008. See Note 6 for additional information regarding income taxes, including the effects of adoption of FIN 48 and FSP FIN 48-1 on our condensed consolidated financial statements.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

NOTE 2. FINANCIAL INSTRUMENTS

We measure certain financial assets and liabilities at fair value on a recurring basis, including cash equivalents, available-for-sale fixed income and equity securities, other equity securities and foreign currency derivatives. The fair value of these financial assets and liabilities was determined using the following inputs at August 29, 2008:

	Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Assets:
Money market funds and overnight deposits(1)	$	939,329	$	939,329	$	—	$	—
Fixed income available-for-sale securities(2)		902,996		—		902,996		—
Equity available-for-sale securities(3)		7,163		7,163		—		—
Investments of limited partnership(4)		37,934		503		—		37,431
Foreign currency derivatives(5)		22,639		—		22,639		—
Total	$	1,910,061	$	946,995	$	925,635	$	37,431
Liabilities:
Foreign currency derivatives(6)		1,124		—		1,124		—
Total	$	1,124	$	—	$	1,124	$	—

_________________________________________

(1) Included in cash and cash equivalents on our condensed consolidated balance sheet.

(2) Included in either cash and cash equivalents or short-term investments on our condensed consolidated balance sheet.

(3) Included in short-term investments on our condensed consolidated balance sheet.

(4) Included in other assets on our condensed consolidated balance sheet.

(5) Included in prepaid expenses and other assets on our condensed consolidated balance sheet.

(6) Included in accrued expenses on our condensed consolidated balance sheet.

Fixed income available-for-sale securities include United States treasury securities (81% of total), corporate bonds (4% of total) and obligations of foreign governments and their agencies (15% of total).

The investments of limited partnership relate to our interest in Adobe Ventures IV L.P. (“Adobe Ventures”) which was $37.9 million and $30.6 million as of August 29, 2008 and November 30, 2007, respectively. The level 1 investments of limited partnership relate to investments in publicly-traded companies and the level 3 investments relate to investments in privately-held companies. Our estimation of fair value for our level 3 investments includes, but is not limited to, reviewing each company’s cash position, financing needs, earnings and revenue outlook, operational performance, management and ownership changes and competition. The change in this asset balance relates primarily to investment gains included in earnings during the three and nine months ended August 29, 2008. All other activity during the quarter was insignificant both individually and in the aggregate. See Note 4 for further information regarding Adobe Ventures and related accounting policies.

Foreign currency derivatives include option and forward foreign exchange contracts primarily for the Japanese Yen and the Euro.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

NOTE 3. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Goodwill as of August 29, 2008 and November 30, 2007 was $2.134 billion and $2.148 billion, respectively. The change includes net reductions in goodwill of $9.6 million related to deferred tax assets associated with our acquisition of Scene7 and $4.2 million related to the tax reserve associated with the acquisition of Macromedia, offset in part by foreign currency changes.

Certain amounts as of November 30, 2007 have been reclassified to conform to current year presentation in the condensed consolidated balance sheets. Specifically, we reclassified $55.5 million of cost and $20.5 million of accumulated amortization ($35.0 million, net) from purchased intangibles to long-term and short-term other assets associated with certain technology license arrangements.

Purchased and other intangible assets subject to amortization were as follows as of August 29, 2008:

	Cost		Accumulated Amortization			Net
Purchased technology	$	411,408	$	(316,637	)	$	94,771
Localization	$	18,342	$	(6,536	)	$	11,806
Trademarks		130,925		(71,709	)		59,216
Customer contracts and relationships		197,220		(117,022	)		80,198
Other intangibles		800		(390	)		410
Total other intangible assets	$	347,287	$	(195,657	)	$	151,630
Total purchased and other intangible assets	$	758,695	$	(512,294	)	$	246,401

Purchased and other intangible assets subject to amortization were as follows as of November 30, 2007:

	Cost		Accumulated Amortization			Net
Purchased technology	$	409,110	$	(250,721	)	$	158,389
Localization	$	45,854	$	(27,676	)	$	18,178
Trademarks		131,225		(52,443	)		78,782
Customer contracts and relationships		197,220		(85,529	)		111,691
Other intangibles		800		(196	)		604
Total other intangible assets	$	375,099	$	(165,844	)	$	209,255
Total purchased and other intangible assets	$	784,209	$	(416,565	)	$	367,644

Amortization expense related to purchased and other intangible assets was $43.2 million and $140.7 million for the three and nine months ended August 29, 2008, respectively. Comparatively, amortization expense was $60.5 million and $157.7 million for the three and nine months ended August 31, 2007, respectively. Of these amounts, $26.2 million and $89.5 million were included in cost of sales for the three and nine months ended August 29, 2008, respectively, and $42.6 million and $104.6 million were included in cost of sales for the three and nine months August 31, 2007, respectively.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

Purchased and other intangible assets are amortized over their estimated useful lives of 1 to 13 years. As of August 29, 2008, we expect amortization expense in future periods as follows:

Fiscal year	Purchased Technology		Other Intangible Assets
Remainder of 2008	$	22,133	$	21,282
2009		56,328		67,633
2010		8,244		48,611
2011		4,679		11,917
2012		3,387		1,009
Thereafter		—		1,178
Total expected amortization expense	$	94,771	$	151,630

NOTE 4. OTHER ASSETS

Other assets consisted of the following as of August 29, 2008 and November 30, 2007:

	2008		2007
Acquired rights to use technology	$	93,527	$	41,642
Investments		70,469		52,830
Security and other deposits		15,478		6,650
Prepaid royalties		12,216		6,748
Deferred compensation plan assets		9,209		3,145
Restricted cash		7,364		7,367
Prepaid land lease		3,195		3,224
Prepaid rent		3,065		4,285
Other		2,364		2,194
Total other assets	$	216,887	$	128,085

Acquired rights to use technology includes $100.0 million associated with certain technology licensing arrangements entered into during the third quarter of fiscal 2008. An estimated $56.0 million of this cost is related to future licensing rights and has been capitalized and will be amortized on a straight-line basis over the estimated useful lives up to nine years. Of the remaining costs, we estimated that approximately $27.2 million was related to historical use of licensing rights which was expensed as cost of sales, and the residual of $16.8 million was expensed as general and administrative costs. In connection with these licensing arrangements, we have the ability to acquire additional rights to use technology in the future. See Note 13 for further information regarding our contractual commitments.

In general, acquired rights to use technology are amortized over their estimated useful lives of 3 to 15 years.

Certain prior year amounts have been reclassified to conform to current year presentation in the condensed consolidated balance sheets. Specifically, there was a reclassification associated with certain technology licensing arrangements totaling $35.0 million, net from purchased intangibles of which $28.7 million and $4.7 million were reclassified to acquired rights to use technology and long-term prepaid royalties, respectively. The remaining amount was reclassified to short-term prepaid royalty.

Included in investments is our limited partnership interest in Adobe Ventures which is consolidated in accordance with FASB Interpretation No. 46R, a revision to FASB Interpretation No. 46, “Consolidation of Variable Interest Entities”. The partnership is controlled by Granite Ventures, an independent venture capital firm and sole general partner of Adobe Ventures. Investments also included our direct investments which were accounted for under the cost method.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

The increase in security and other deposits relates primarily to the purchase of real property in Massachusetts. We entered into a Purchase and Sale Agreement, effective May 12, 2008, for the acquisition of real property located in Waltham, Massachusetts. We will purchase the property subject to completion of construction of an office building shell and core, parking structure and site improvements. The purchase price for the property will be $44.7 million. We made an initial deposit of $7.0 million to be held in escrow until closing and then applied to the purchase price. Closing is expected to occur in May 2009 and the remaining balance is due at such time.

NOTE 5. TRADE AND OTHER PAYABLES AND ACCRUED EXPENSES

Trade and other payables consisted of the following as of August 29, 2008 and November 30, 2007:

	2008		2007
Trade payables	$	38,150	$	41,724
Sales and use tax and other payables		18,104		25,143
Total trade and other payables	$	56,254	$	66,867

Accrued expenses consisted of the following as of August 29, 2008 and November 30, 2007:

	2008		2007
Accrued compensation and benefits	$	173,199	$	205,018
Sales and marketing allowances		23,707		21,231
Other		159,502		157,187
Total accrued expenses	$	356,408	$	383,436

Other primarily includes general corporate accruals for corporate marketing programs, local and regional expenses, charitable contributions and technical support. Other is also comprised of deferred rent related to office locations with rent escalations, accrued royalties, foreign currency derivatives and accrued interest on the credit facility.

NOTE 6. INCOME TAXES

We adopted both FIN 48 and FSP FIN 48-1 on December 1, 2007. The adoption of FIN 48 resulted in an increase of $3.9 million to both assets and liabilities in our condensed consolidated balance sheet as of the beginning of fiscal 2008. Upon adoption, the gross liability for unrecognized tax benefits at December 1, 2007 was $218.4 million, exclusive of interest and penalties. The total amount of gross FIN 48 liabilities includes $57.7 million that relates to certain tax attributes from acquired companies, including Macromedia. These liabilities from acquired companies are not recorded on our balance sheet because they are related to positions that have not yet been claimed on our income tax returns. If the total FIN 48 gross liability for unrecognized tax benefits at December 1, 2007 were recognized in the future, the following amounts, net of an estimated $22.2 million benefit related to deducting such payments on future tax returns, would result: $99.0 million of unrecognized tax benefits would decrease the effective tax rate, $82.8 million would decrease goodwill and $14.4 million would increase additional paid-in-capital.

We have historically presented our estimated liability for unrecognized tax benefits as a current liability. FIN 48 requires liabilities for unrecognized tax benefits to be classified based on whether a payment is expected to be made within the next 12 months. That is, amounts expected to be paid within the next 12 months are to be classified as a current liability and all other amounts are to be classified as a non-current liability. As a result of adopting FIN 48 in the first quarter of fiscal 2008, we reclassified $197.7 million from current income taxes payable to long-term income taxes payable, including accrued interest on the balance.

We have historically presented our estimated state, local and interest liabilities net of the estimated benefit we expect to receive from deducting such payments on future tax returns (i.e., on a “net” basis). FIN 48 requires this estimated benefit to be classified as a deferred tax asset instead of a reduction of the overall liability (i.e., on a “gross” basis). Thus, we recognized additional deferred income tax assets of $3.9 million to present the unrecognized tax benefits as gross amounts on our condensed consolidated balance sheet.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

Our policy to classify interest and penalties on unrecognized tax benefits as income tax expense did not change upon the adoption of FIN 48. As of December 1, 2007, the combined amount of accrued interest and penalties related to tax positions taken on our tax returns and included in non-current income taxes payable was approximately $42.8 million.

We file income tax returns in the U.S. on a federal basis and in many U.S. state and foreign jurisdictions. We are subject to the continual examination of our income tax returns by the Internal Revenue Service (“IRS”) and other domestic and foreign tax authorities. Our major tax jurisdictions are the U.S., Ireland and California. For California, Ireland and the U.S., the earliest fiscal years open for examination are 2001, 2002 and 2005, respectively.

During the nine months ended August 29, 2008, the gross liability for unrecognized tax benefits significantly changed from the balance at November, 30, 2007. In August 2008, a U.S. income tax examination covering our fiscal years 2001 through 2004 was completed. Our accrued tax and interest related to these years was $100.0 million and was previously reported in long-term income taxes payable. In conjunction with this resolution, we requested and received approval from the IRS to repatriate certain foreign earnings in a tax-free manner, which resulted in a reduction of our long-term deferred income tax liability of $57.8 million. Together, these liabilities on our balance sheet decreased by $157.8 million. Also in August 2008, we paid $80.0 million in conjunction with the aforementioned resolution, credited additional paid-in-capital for $41.3 million due to our use of certain tax attributes related to stock option deductions, including a portion of certain deferred tax assets not recorded in our financial statements pursuant to SFAS 123R, and made other individually immaterial adjustments to our tax balances totaling $15.8 million. A net income statement tax benefit in the third quarter of fiscal 2008 of $20.7 million resulted. All other movements in the deferred tax asset and liability accounts are the result of our normal 2008 tax provision.

The gross liability for unrecognized tax benefits at August 29, 2008 was $155.8 million, exclusive of interest and penalties. If the total FIN 48 gross liability for unrecognized tax benefits at August 29, 2008 were recognized in the future, the following amounts, net of an estimated $18.1 million benefit related to deducting such payments on future tax returns, would result: $54.7 million of unrecognized tax benefits would decrease the effective tax rate and $83.0 million would decrease goodwill.

As of August 29, 2008, the combined amount of accrued interest and penalties related to tax positions taken on our tax returns and included in non-current income taxes payable was approximately $14.3 million.

The timing of the resolution of income tax examinations is highly uncertain, and the amounts ultimately paid, if any, upon resolution of the issues raised by the taxing authorities may differ materially from the amounts accrued for each year. While it is reasonably possible that some issues in the IRS and other examinations could be resolved within the next 12 months, based upon the current facts and circumstances, we cannot estimate the timing of such resolution or range of potential changes as it relates to the unrecognized tax benefits that are recorded as part of our financial statements.

NOTE 7. STOCK-BASED COMPENSATION

The assumptions used to value option grants, restricted stock units and performance shares during the three and nine months ended August 29, 2008 and August 31, 2007 are as follows:

	Three Months Ended						Nine Months Ended
	2008			2007			2008			2007
Expected life (in years)		3.5 – 3.6			3.6 – 3.7			2.3 – 4.7			3.5 – 4.8
Volatility		34 – 37	%		30 – 34	%		32 – 39	%		30 – 34	%
Risk free interest rate		2.79 – 3.50	%		4.34 – 5.14	%		1.70 – 3.50	%		4.34 – 5.14	%

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

The expected term of employee stock purchase plan (“ESPP”) shares is the average of the remaining purchase periods under each offering period. The assumptions used to value employee stock purchase rights during the three and nine months ended August 29, 2008 and August 31, 2007 are as follows:

	Three Months Ended						Nine Months Ended
	2008			2007			2008			2007
Expected life (in years)		0.5 – 2.0			0.5 – 2.0			0.5 – 2.0			0.5 – 2.0
Volatility		34 – 36	%		30 – 31	%		30 – 36	%		30 – 33	%
Risk free interest rate		2.12 – 2.66	%		4.87 – 4.93	%		2.12 – 3.29	%		4.79 – 5.11	%

Effective April 1, 2007, the government of India implemented a new fringe benefit tax that applies to equity awards granted to our employees in India. We incur a fringe benefit tax liability at the time the award is exercised or released. In accordance with the laws in India, we have elected to recover, from the employee, the fringe benefit tax paid in connection with the applicable award. Recovery of the fringe benefit tax from the employee is treated as a component of the exercise price and as such, impacts the fair value of the awards and the related stock-based compensation. We have elected to use a Black-Scholes option pricing model that incorporates a binomial options pricing model to calculate the fair value of stock-based awards issued in India under amended equity award agreements. The assumptions used in the valuation of equity awards in India are the same as those used for all of our equity awards as noted above. The recovery of fringe benefit tax is recorded as stock-based compensation cost in our consolidated statements of income.

Summary of Stock Options

Information regarding stock options outstanding at August 29, 2008 and August 31, 2007 is summarized below.

	Number of Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value* (millions)
2008
Options outstanding		42,070	$	29.67	4.16 years	$	554.5
Options vested and expected to vest		39,936	$	29.29	4.07 years	$	541.2
Options exercisable		27,252	$	25.94	3.35 years	$	460.3

2007
Options outstanding		54,744	$	27.59	3.93 years	$	830.1
Options vested and expected to vest		51,832	$	27.10	3.84 years	$	811.4
Options exercisable		34,252	$	22.95	3.06 years	$	678.1

_________________________________________

*	The intrinsic value is calculated as the difference between the market value as of the end of the fiscal period and the exercise price of the shares. As reported by the NASDAQ Global Select Market, the market values as of August 29, 2008 and August 31, 2007 were $42.83 and $42.75, respectively.

Summary of Restricted Stock Units

Restricted stock unit activity for the nine months ended August 29, 2008 and August 31, 2007 is as follows:

	2008			2007
Beginning balance		1,701			—
Awarded		2,823			1,458
Released		(353	)		—
Forfeited		(146	)		(47	)
Ending balance		4,025			1,411

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

Information regarding restricted stock units outstanding at August 29, 2008 and August 31, 2007 is summarized below.

	Number of Shares		Weighted Average Remaining Contractual Life	Aggregate Intrinsic Value* (millions)
2008
Restricted stock units outstanding		4,025	1.91 years	$	172.4
Restricted stock units expected to vest		3,083	1.69 years	$	132.0

2007
Restricted stock units outstanding		1,411	2.02 years	$	60.3
Restricted stock units expected to vest		981	1.79 years	$	42.0

_________________________________________

*	The intrinsic value is calculated as the difference between the market value as of the end of the fiscal period and the exercise price of the shares. As reported by the NASDAQ Global Select Market, the market values as of August 29, 2008 and August 31, 2007 were $42.83 and $42.75, respectively.

Summary of Performance Shares

Effective January 24, 2008, the Executive Compensation Committee adopted the 2008 Performance Share Program (the “2008 Program”). The purpose of the 2008 Program is to align key management and senior leadership with stockholders’ interests and to retain key employees. The measurement period for the 2008 Program is our fiscal 2008 year. All members of our executive management and other key senior leaders are participating in the 2008 Program. Awards granted under the 2008 Program were granted in the form of performance shares pursuant to the terms of our 2003 Equity Incentive Plan. If pre-determined performance goals are met, shares of stock will be granted to the recipient, with 25% vesting on the later of the date of certification of achievement or the first anniversary date of the grant, 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 2008 Program have the ability to receive up to 200% of the target number of shares originally granted.

The following table sets forth the summary of performance share activity under our 2008 Program for the nine months ended August 29, 2008.

	Shares Granted			Maximum Shares Eligible to Receive
Beginning balance		—			—
Awarded		931			1,863
Forfeited		(74	)		(149	)
Ending balance		857			1,714

In the first quarter of fiscal 2008, the Executive Compensation Committee certified the actual performance achievement of participants in the 2006 Performance Share Program (the “2006 Program”) and the 2007 Performance Share Program (the “2007 Program”). Based upon the achievement of goals outlined in the 2006 Program and 2007 Program, participants had the ability to receive up to 150% and 200%, respectively, of the target number of shares originally granted. Actual performance resulted in participants achieving approximately 105% of target or 0.3 million shares for the 2006 Program and 200% of target or 0.7 million shares for the 2007 Program. Shares awarded under the 2006 Program vested 100% and were released in the first quarter of fiscal 2008. Shares under the 2007 Program vested 25% in the first quarter of fiscal 2008, and the remaining 75% vest evenly on the following three annual anniversary dates of the grant, contingent upon the recipient’s continued service to Adobe.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

The following table sets forth the summary of performance share activity under our 2007 Program, based upon share awards actually achieved, for the nine months ended August 29, 2008:

	Shares
Shares achieved		718
Released		(205	)
Forfeited		(59	)
Ending balance		454

Compensation Costs

As of August 29, 2008, there was $301.8 million of unrecognized compensation cost, adjusted for estimated forfeitures, related to non-vested stock-based awards which will be recognized over a weighted average period of 2.7 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.

Total stock-based compensation costs that have been included in our consolidated statements of income for the three months ended August 29, 2008 and August 31, 2007 are as follows:

	2008				2007
Income Statement Classifications	Option Grants and Stock Purchase Rights *		Restricted Stock and Performance Share Awards *		Option Grants and Stock Purchase Rights		Restricted Stock and Performance Share Awards
Cost of revenue—services and support	$	1,189	$	230	$	1,443	$	98
Research and development		15,612		6,377		16,664		2,230
Sales and marketing		10,576		5,370		10,414		1,330
General and administrative		6,113		2,793		5,857		671
Total	$	33,490	$	14,770	$	34,378	$	4,329

_________________________________________

*	For the three months ended August 29, 2008, we recorded $2.1 million associated with cash recoveries of fringe benefit tax from employees in India.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

Total stock-based compensation costs that have been included in our consolidated statements of income for the nine months ended August 29, 2008 and August 31, 2007 are as follows:

	2008				2007
Income Statement Classifications	Option Grants and Stock Purchase Rights *		Restricted Stock and Performance Share Awards *		Option Grants and Stock Purchase Rights		Restricted Stock and Performance Share Awards
Cost of revenue—services and support	$	2,968	$	483	$	4,059	$	225
Research and development		43,382		16,380		44,192		5,965
Sales and marketing		31,701		15,558		31,071		3,954
General and administrative		18,841		10,368		18,966		1,764
Total	$	96,892	$	42,789	$	98,288	$	11,908

_________________________________________

*	For the nine months ended August 29, 2008, we recorded $2.1 million associated with cash recoveries of fringe benefit tax from employees in India.

NOTE 8. EMPLOYEE BENEFIT PLAN

Deferred Compensation Plan

As of August 29, 2008 and November 30, 2007, the invested amounts under our Deferred Compensation Plan totaled $9.2 million and $3.1 million, respectively, and are recorded as long-term other assets on our balance sheet. As of August 29, 2008 and November 30, 2007, we recorded $9.2 million and $3.1 million, respectively, as a long-term liability to recognize undistributed deferred compensation due to employees.

NOTE 9. RESTRUCTURING AND OTHER CHARGES

Macromedia Merger Restructuring Charges

We completed our acquisition of Macromedia on December 3, 2005. We recognized costs related to the cancellation of certain contracts associated with the wind-down of subsidiaries and other service contracts held by Macromedia.

The following table sets forth a summary of Macromedia restructuring activities during the nine months ended August 29, 2008:

	November 30, 2007		Cash Payments			Adjustments			August 29, 2008		Total Costs Incurred To Date		Total Costs Expected to be Incurred
Termination benefits	$	—	$	—		$	—		$	—	$	26,976	$	26,976
Cost of closing redundant facilities		16,283		(5,287	)		2,969			13,965		28,248		42,213
Cost of contract termination		—		—			—			—		3,238		3,238
Other		1,435		(131	)		(311	)		993		1,363		2,356
Total	$	17,718	$	(5,418	)	$	2,658		$	14,958	$	59,825	$	74,783

Included in the adjustments column is a change to previous estimates of sublease income of $2.6 million associated with closing redundant facilities as well as the effect of foreign currency changes. The change to previous estimates of sublease income was included in net income for the nine months ended August 29, 2008. Accrued restructuring charges of $15.0 million at August 29, 2008 included $6.9 million recorded in accrued restructuring, current and $8.1 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. At November 30, 2007, accrued restructuring charges

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

of $17.7 million included $3.7 million recorded in accrued restructuring, current and $14.0 million related to long-term facilities obligations recorded in accrued restructuring, non-current in the accompanying condensed consolidated balance sheets.

NOTE 10. 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 also enter into structured repurchases with third parties.

During the nine months ended August 29, 2008 and August 31, 2007, we entered into several structured repurchase agreements with large financial institutions, whereupon we provided the financial institutions with prepayments of $325.0 million and $600.0 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 common stock over a specified period of time. We only enter into such transactions when the discount that we receive is higher than the foregone return on our cash prepayments to the financial institutions. There were no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us.

The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval and the average VWAP of our stock during the interval less the agreed upon discount. During the nine months ended August 29, 2008, we repurchased 19.0 million shares at an average price of $37.12 through structured repurchase agreements which included prepayments from fiscal 2007. During the nine months ended August 31, 2007, we repurchased 15.4 million shares at an average price of $39.23 through structured repurchase agreements which included prepayments from fiscal 2006.

During the nine months ended August 29, 2008, we also repurchased 0.75 million shares at an average price of $39.19 in open market transactions.

As of August 29, 2008 and November 30, 2007, the prepayments were classified as treasury stock on our balance sheet at the payment date, though only shares physically delivered to us by August 29, 2008 and November 30, 2007 are excluded from the denominator in the computation of earnings per share. All outstanding structured repurchase agreements as of August 29, 2008 under this program expired on or before September 19, 2008. As of August 29, 2008 and August 31, 2007, approximately $41.0 million and $200.0 million, respectively, of up-front payments remained under the agreements.

Subsequent to August 29, 2008, we entered into additional structured stock repurchase agreements with large financial institutions whereupon we provided the financial institutions with prepayments of $200.0 million. This amount will be classified as treasury stock on our balance sheet.

Stock Repurchase Program II

Under this stock repurchase program, we had authorization to repurchase 50.0 million shares of our common stock. During the third quarter of fiscal 2008, the remaining authorized number of shares were repurchased. From the inception of the 50.0 million share authorization under this program, we provided prepayments of $1.9 billion under structured share repurchase agreements to large financial institutions. During the nine months ended August 29, 2008, we provided prepayments of $1.0 billion and repurchased 31.9 million shares under these structured agreements at an average price of $37.15. As of August 31, 2007, we had provided prepayments of $850.0 million and repurchased 12.9 million shares through structured share repurchase agreements at an average price of $39.94. Approximately $333.4 million of up-front payments remained as of August 31, 2007.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

During the nine months ended August 29, 2008, we also repurchased 0.5 million shares at an average price of $39.79 in open market transactions.

NOTE 11. COMPREHENSIVE INCOME

The following table sets forth the components of comprehensive income for the three and nine months ended August 29, 2008 and August 31, 2007:

	Three Months						Nine Months
	2008			2007			2008			2007
Net income	$	191,608		$	205,243		$	625,897		$	501,599
Other comprehensive income (loss):
Change in unrealized gain (loss) on available-for-sale securities, net of taxes		(1,998	)		700			(11,001	)		5,568
Currency translation adjustments		(6,358	)		21			(4,284	)		1,746
Net gain (loss) in derivative instruments, net of taxes		10,494			(3,776	)		10,776			42
Other comprehensive income (loss)		2,138			(3,055	)		(4,509	)		7,356
Total comprehensive income, net of taxes	$	193,746		$	202,188		$	621,388		$	508,955

NOTE 12. NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share for the three and nine months ended August 29, 2008 and August 31, 2007:

	Three Months				Nine Months
	2008		2007		2008		2007
Net income	$	191,608	$	205,243	$	625,897	$	501,599
Shares used to compute basic net income per share		531,060		583,670		542,624		587,141
Dilutive potential common shares:
Unvested restricted stock and performance share awards		1,063		11		991		13
Stock options		9,188		13,653		9,124		15,109
Shares used to compute diluted net income per share		541,311		597,334		552,739		602,263
Basic net income per share	$	0.36	$	0.35	$	1.15	$	0.85
Diluted net income per share	$	0.35	$	0.34	$	1.13	$	0.83

For the three and nine months ended August 29, 2008, options to purchase approximately 14.4 million and 15.4 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $42.06 and $39.21, respectively, were not included in the calculation because the effect would have been anti-dilutive. Comparatively, for the three and nine months ended August 31, 2007, options to purchase approximately 11.9 million and 11.0 million shares, respectively, of common stock with exercise prices greater than the average fair market value of our stock of $41.26 and $40.93, respectively, were not included in the calculation because the effect would have been anti-dilutive.

NOTE 13. 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

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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 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 August 29, 2008, 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 SFAS 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.

Contractual Commitments

As discussed in Note 4, during the third quarter of fiscal 2008, we entered into an agreement to license certain technology. This agreement also provides us the ability to acquire rights to intellectual property in the future. Minimum fees associated with this arrangement range between approximately $1.0 million and $1.5 million per year through May 2028 for minimum fees in the aggregate, of approximately $25.0 million.

Guarantees

The lease agreements for our corporate headquarters provide for residual value guarantees as noted above. 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 $5.2 million and $3.0 million in liabilities, related to the East and West Towers and Almaden Tower leases, respectively. 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 August 29, 2008 and November 30, 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 $3.0 million and $4.2 million, respectively.

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 directors and officers for certain events or occurrences while the director or officer is, or was serving, at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the director’s or officer’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited;

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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 interest 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 partnership. 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

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.

From time to time, Adobe is subject to legal proceedings, claims and investigations 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 GAAP, 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 negatively affected by an unfavorable resolution of one or more of such proceedings, claims or investigations.

NOTE 14. CREDIT AGREEMENT

In August 2007, we entered into an Amendment to our Credit Agreement dated February 2007 (the “Amendment”), which increased the total senior unsecured revolving facility from $500.0 million to $1.0 billion. The Amendment also permits us to request one-year extensions effective on each anniversary of the closing date of the original agreement, subject to the majority consent of the lenders. We also retain an option to request an additional $500.0 million in commitments, for a maximum aggregate facility of $1.5 billion.

In February 2008, we entered into a Second Amendment to the Credit Agreement dated February 26, 2008, which extended the maturity date of the facility by one year to February 16, 2013. The facility would terminate at this date if no additional extensions have been requested and granted. All other terms and conditions remain the same.

The facility contains a financial covenant requiring us not to exceed a certain maximum leverage ratio. At the Company’s option, borrowings under the facility accrue interest based on either the London interbank offered rate (“LIBOR”) for one, two, three or six months, or longer periods with bank consent, plus a margin according to a pricing grid tied to this financial covenant, or a base rate. The margin is set at rates between 0.20% and 0.475%. Commitment fees are payable on the facility at rates between 0.05% and 0.15% per year based on the same pricing grid. The facility is available to provide loans to us and certain of our subsidiaries for general corporate purposes. During the nine months ended August 29, 2008, we borrowed $450.0 million and made repayments of $100.0 million under this facility. As of August 29, 2008 and November 30, 2007, the amount outstanding under the credit facility was $350.0 million and zero, respectively, which is included in long-term liabilities on our condensed consolidated balance sheet. As of August 29, 2008, we were in compliance with all of the covenants.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

NOTE 15. NON-OPERATING INCOME (EXPENSE)

Non-operating income (expense) for the three and nine months ended August 29, 2008 and August 31, 2007 includes the following:

	Three Months						Nine Months
	2008			2007			2008			2007
Interest and other income, net:
Interest income	$	14,407		$	22,780		$	45,110		$	71,268
Foreign exchange gains (losses)		(5,967	)		99			(11,901	)		(4,172	)
Fixed income investment gains (losses)		44			(249	)		(156	)		(2,636	)
Other		854			103			1,725			1,406
Interest and other income, net	$	9,338		$	22,733		$	34,778		$	65,866
Interest expense	$	(2,390	)	$	(69	)	$	(8,027	)	$	(175	)
Investment gains (losses), net:
Realized investment gains	$	2,861		$	198		$	18,298		$	9,308
Unrealized investment gains		2,882			—			7,840			5,091
Realized investment losses		(353	)		(624	)		(989	)		(1,784	)
Unrealized investment losses		(3,293	)		(268	)		(4,814	)		(3,546	)
Investment gains (losses), net	$	2,097		$	(694	)	$	20,335		$	9,069
Total non-operating income, net	$	9,045		$	21,970		$	47,086		$	74,760

NOTE 16. INDUSTRY SEGMENTS

We have the following segments: Creative Solutions, Knowledge Worker Solutions, Enterprise Solutions, Mobile and Device Solutions, Platform and Print Publishing. 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. 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 Acrobat Connect and our Acrobat family of products. Our Enterprise Solutions segment provides server-based enterprise interaction solutions that automate people-centric processes and contains revenue generated by our LiveCycle line of products. The Mobile and Device Solutions segment provides solutions that deliver 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. The Platform segment provides developer solutions and technologies, including Adobe Flash Player, Adobe AIR and Flex Builder which are used to build rich application experiences. Finally, the Print Publishing segment addresses market opportunities ranging from the diverse publishing needs of technical and business publishing, to our legacy type and original equipment manufacturer (“OEM”) printing businesses.

Effective in the first quarter of fiscal 2008, to better align our engineering and marketing efforts, we merged our Knowledge Worker Solutions segment with our Enterprise Solutions segment (formerly “Enterprise and Developer Solutions”) to form our new Business Productivity Solutions business unit. However, under the requirements of SFAS No. 131, (“SFAS 131”), “Disclosures about Segments of an Enterprise and Related Information”, Knowledge Worker Solutions and Enterprise Solutions are separate reportable segments. In addition, we moved responsibility for Flex Builder, Flex SDK and our ColdFusion product line to our Platform segment from our Enterprise Solutions segment. The prior year information in the table below has also been updated to reflect this product movement.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(In thousands, except share and per share data)

(Unaudited)

Our chief operating decision maker reviews revenue and gross margin information for each of our operating segments. Operating expenses are not reviewed on a segment by segment basis. In addition, with the exception of goodwill and intangible assets, we do not identify or allocate our assets by the operating segments.

	Creative Solutions			Knowledge Worker Solutions			Enterprise Solutions			Mobile and Device Solutions			Platform			Print Publishing			Total
Three months ended August 29, 2008
Revenue	$	493,615		$	217,988		$	65,491		$	27,495		$	31,582		$	51,086		$	887,257
Cost of revenue		53,716			15,762			20,727			6,744			7,393			6,509			110,851
Gross profit	$	439,899		$	202,226		$	44,764		$	20,751		$	24,189		$	44,577		$	776,406
Gross profit as a percentage of revenue		89	%		93	%		68	%		75	%		77	%		87	%		88	%
Three months ended August 31, 2007
Revenue	$	545,453		$	176,764		$	50,628		$	12,983		$	18,693		$	47,165		$	851,686
Cost of revenue		40,114			15,969			18,238			9,521			3,240			5,539			92,621
Gross profit	$	505,339		$	160,795		$	32,390		$	3,462		$	15,453		$	41,626		$	759,065
Gross profit as a percentage of revenue		93	%		91	%		64	%		27	%		83	%		88	%		89	%

	Creative Solutions			Knowledge Worker Solutions			Enterprise Solutions			Mobile and Device Solutions			Platform			Print Publishing			Total
Nine months ended August 29, 2008
Revenue	$	1,564,335		$	611,925		$	174,011		$	64,919		$	90,117		$	159,281		$	2,664,588
Cost of revenue		124,024			39,476			56,308			19,525			15,821			21,038			276,192
Gross profit	$	1,440,311		$	572,449		$	117,703		$	45,394		$	74,296		$	138,243		$	2,388,396
Gross profit as a percentage of revenue		92	%		94	%		68	%		70	%		82	%		87	%		90	%
Nine months ended August 31, 2007
Revenue	$	1,328,463		$	536,382		$	137,044		$	38,999		$	53,359		$	152,423		$	2,246,670
Cost of revenue		103,023			47,473			53,237			23,206			9,846			19,313			256,098
Gross profit	$	1,225,440		$	488,909		$	83,807		$	15,793		$	43,513		$	133,110		$	1,990,572
Gross profit as a percentage of revenue		92	%		91	%		61	%		40	%		82	%		87	%		89	%

NOTE 17. SUBSEQUENT EVENTS

Stock Repurchase Programs

Subsequent to August 29, 2008, as part of Stock Repurchase Program I, we entered into additional structured stock repurchase agreements with large financial institutions whereupon we provided the financial institutions with prepayments of $200.0 million. This amount will be classified as treasury stock on our balance sheet. See Note 10 for further discussion of our stock repurchase programs.

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

The following discussion (unaudited and presented in millions, except share and per share amounts) 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 from these forward-looking statements. Factors that might cause or contribute to such differences include, but are not limited to, those discussed in the section entitled “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 SEC, including the Annual Report on Form 10-K for fiscal 2007 and the other Quarterly Reports on Form 10-Q filed by us in fiscal 2008. 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 creative professionals, designers, knowledge workers, high-end consumers, 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 Web site at www.adobe.com. We also license our technology to 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, the Middle East and Africa (“EMEA”) and Asia. Our software runs on personal computers with Microsoft Windows, Apple OS, Linux, UNIX and various non-PC 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

Effective in the first quarter of fiscal 2008, to better align our engineering and marketing efforts, we merged our Knowledge Worker Solutions segment with our Enterprise Solutions segment to form our new Business Productivity Solutions business unit. However, under the requirements of SFAS 131, Knowledge Worker Solutions and Enterprise Solutions are separate reportable segments. In addition, we moved responsibility for Flex Builder, Flex SDK and our ColdFusion product line to our Platform segment from our Enterprise Solutions segment. The prior year information has been updated to reflect this product movement.

During the third quarter of fiscal 2008, we continued to focus on driving revenue growth and increasing market share of our products through the continued delivery of comprehensive software and technology solutions that meet the evolving needs of our customers.

In our Knowledge Worker Solutions segment, we achieved a fourth consecutive quarter of record revenue with our Acrobat family of products in the third quarter of fiscal 2008. Helping drive this achievement was the successful launch of version 9 of our Acrobat family of products in major languages across the world.

In our Enterprise Solutions segment, we also achieved record revenue and 29% year-over-year growth as we continued to focus on delivering innovative products and solutions for our enterprise customers.

In our Creative Solutions segment, revenue declined year-over-year due to the timing of the release of new product versions. In the third quarter of fiscal 2007, we completed the release of many new versions of our Creative Suite 3 (“CS3”)

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family of products. In the third quarter of fiscal 2008, we began preparing for the next launch of our creative professional products, including the pre-release of newer versions of some of these products. We achieved solid results with our hobbyist

products, Photoshop Elements and Premiere Elements, and we also had strong results with our Scene7 business in the third quarter of fiscal 2008.

Our Mobile and Device Solutions segment achieved record revenue in the third quarter of fiscal 2008 due to the success we have had targeting mobile operators, handset manufacturers and consumer electronic device manufactures with our Flash Lite and Flash Cast technologies. On May 1, 2008, we announced the Open Screen Project. The project aims to enable a consistent runtime environment that will remove barriers for developers and designers as they publish content and applications across desktops and consumer devices, including phones, mobile internet devices (“MIDs”) and set top boxes. As part of the project, we will be removing some restrictions on the use of some of our technology specifications and publishing several technology protocols. We will also be removing the license fees on the next major releases of Adobe Flash Player and Adobe AIR for devices. Accordingly, we expect revenue from Mobile and Device Solutions to decrease in the fourth quarter of fiscal 2008 as well as to continue to decrease following the next major release of these products scheduled for fiscal 2009. We would expect this decrease to be offset in time by an increased demand for tooling products, server technologies, hosted services and applications.

Our Platform business performed strongly, resulting in significant year-over-year revenue growth and our Print Publishing business segment also achieved modest year-over-year revenue growth.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

In preparing our condensed consolidated financial statements in accordance with GAAP and pursuant to the rules and regulations of the SEC, we make assumptions, judgments and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosures of contingent assets and liabilities. 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. We also discuss our critical accounting policies and 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 impairment and income taxes have the greatest potential impact on our condensed 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 critical accounting policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.

With the exception of our adoption of FIN 48, there have been no other significant changes in our critical accounting policies and estimates during the nine months ended August 29, 2008 as compared to the critical accounting policies and estimates disclosed in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended November 30, 2007.

RESULTS OF OPERATIONS

Revenue for the Three and Nine Months Ended August 29, 2008 and August 31, 2007

	Three Months						Percent			Nine Months						Percent
	2008			2007			Change			2008			2007			Change
Product	$	838.9		$	813.4			3	%	$	2,532.1		$	2,147.2			18	%
Percentage of total revenue		95	%		96	%					95	%		96	%
Services and support		48.4			38.3			26	%		132.5			99.5			33	%
Percentage of total revenue		5	%		4	%					5	%		4	%
Total revenue	$	887.3		$	851.7			4	%	$	2,664.6		$	2,246.7			19	%

As described in Note 16 of our Notes to Condensed Consolidated Financial Statements, we have the following segments: Creative Solutions, Knowledge Worker Solutions, Enterprise Solutions, Mobile and Device Solutions, Platform and Print Publishing products.

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Our services and support revenue is comprised of consulting, training, and maintenance and support, primarily related to the licensing of our enterprise, developer and platform products. Our support revenue also includes technical support and developer support to partners and developer organizations related to our desktop products. Our maintenance and support offerings which entitle customers to receive product upgrades and enhancements or technical support, depending on the offering, are recognized ratably over the term of the arrangement.

Segment Information

	Three Months						Percent			Nine Months						Percent
	2008			2007			Change			2008			2007			Change
Creative Solutions	$	493.6		$	545.5			(10	)%	$	1,564.3		$	1,328.5			18	%
Percentage of total revenue		56	%		64	%					59	%		59	%
Knowledge Worker Solutions		218.0			176.8			23	%		611.9			536.4			14	%
Percentage of total revenue		25	%		21	%					23	%		24	%
Enterprise Solutions		65.5			50.6			29	%		174.1			137.1			27	%
Percentage of total revenue		7	%		6	%					7	%		6	%
Mobile and Device Solutions		27.5			13.0			112	%		64.9			39.0			66	%
Percentage of total revenue		3	%		1	%					2	%		2	%
Platform		31.6			18.7			69	%		90.1			53.4			69	%
Percentage of total revenue		3	%		2	%					3	%		2	%
Print Publishing		51.1			47.1			8	%		159.3			152.3			5	%
Percentage of total revenue		6	%		6	%					6	%		7	%
Total revenue	$	887.3		$	851.7			4	%	$	2,664.6		$	2,246.7			19	%