Edgar Filing: ADOBE SYSTEMS INC

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_________________________

FORM 10-Q

(Mark One)



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

For the quarterly period ended March 2, 2018



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

For the transition period from to

Commission File Number: 0-15175

ADOBE SYSTEMS INCORPORATED

(Exact name of registrant as specified in its charter)

_________________________



Delaware (State or other jurisdiction of incorporation or organization)	77-0019522 (I.R.S. Employer Identification No.)

345 Park Avenue, San Jose, California 95110-2704

(Address of principal executive offices and zip code)

(408) 536-6000

(Registrant’s telephone number, including area code)

_________________________

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer x	Accelerated filer o	Non-accelerated filer o (Do not check if a smaller reporting company)	Smaller reporting company o	Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No x

The number of shares outstanding of the registrant’s common stock as of March 23, 2018 was 492,470,335.

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 March 2, 2018 and December 1, 2017	3
	Condensed Consolidated Statements of Income Three Months Ended March 2, 2018 and March 3, 2017	4
	Condensed Consolidated Statements of Comprehensive Income Three Months Ended March 2, 2018 and March 3, 2017	5
	Condensed Consolidated Statements of Cash Flows Three Months Ended March 2, 2018 and March 3, 2017	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	39
Item 4.	Controls and Procedures	40

PART II—OTHER INFORMATION
Item 1.	Legal Proceedings	40
Item 1A.	Risk Factors	40
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	52
Item 4.	Mine Safety Disclosures	52
Item 5.	Other Information	52
Item 6.	Exhibits	53
Signature		58
Summary of Trademarks		59

Table of Contents

PART I—FINANCIAL INFORMATION

ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)



	March 2, 2018			December 1, 2017
	(Unaudited)			(*)
ASSETS
Current assets:
Cash and cash equivalents	$	2,666,981		$	2,306,072
Short-term investments	3,480,989			3,513,702
Trade receivables, net of allowances for doubtful accounts of $9,284 and $9,151, respectively	1,062,690			1,217,968
Prepaid expenses and other current assets	270,154			210,071
Total current assets	7,480,814			7,247,813
Property and equipment, net	991,674			936,976
Goodwill	5,843,899			5,821,561
Purchased and other intangibles, net	353,740			385,658
Deferred income taxes	149,710			—
Other assets	153,648			143,548
Total assets	$	14,973,485		$	14,535,556

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade payables	$	131,090		$	113,538
Accrued expenses	911,044			993,773
Income taxes payable	10,591			14,196
Deferred revenue	2,483,744			2,405,950
Total current liabilities	3,536,469			3,527,457
Long-term liabilities:
Debt	1,874,794			1,881,421
Deferred revenue	88,460			88,592
Income taxes payable	690,468			173,088
Deferred income taxes	—			279,941
Other liabilities	149,266			125,188
Total liabilities	6,339,457			6,075,687
Stockholders’ equity:
Preferred stock, $0.0001 par value; 2,000 shares authorized, none issued	—			—
Common stock, $0.0001 par value; 900,000 shares authorized; 600,834 shares issued; 492,880 and 491,262 shares outstanding, respectively	61			61
Additional paid-in-capital	5,208,588			5,082,195
Retained earnings	9,830,399			9,573,870
Accumulated other comprehensive income (loss)	(109,939		)	(111,821		)
Treasury stock, at cost (107,954 and 109,572 shares, respectively), net of reissuances	(6,295,081		)	(6,084,436		)
Total stockholders’ equity	8,634,028			8,459,869
Total liabilities and stockholders’ equity	$	14,973,485		$	14,535,556

^{_________________________________________}


(*)	The condensed consolidated balance sheet as of December 1, 2017 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

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 Ended
	March 2, 2018			March 3, 2017
Revenue:
Subscription	$	1,793,358		$	1,383,856
Product	171,608			183,385
Services and support	113,981			114,405
Total revenue	2,078,947			1,681,646
Cost of revenue:
Subscription	164,685			141,181
Product	12,877			14,333
Services and support	81,340			81,823
Total cost of revenue	258,902			237,337
Gross profit	1,820,045			1,444,309
Operating expenses:
Research and development	348,769			285,077
Sales and marketing	580,957			520,297
General and administrative	170,440			150,808
Amortization of purchased intangibles	17,146			19,128
Total operating expenses	1,117,312			975,310
Operating income	702,733			468,999
Non-operating income (expense):
Interest and other income (expense), net	16,672			7,206
Interest expense	(19,899		)	(18,130		)
Investment gains (losses), net	2,996			2,557
Total non-operating income (expense), net	(231		)	(8,367		)
Income before income taxes	702,502			460,632
Provision for income taxes	119,426			62,186
Net income	$	583,076		$	398,446
Basic net income per share	$	1.18		$	0.81
Shares used to compute basic net income per share	492,061			494,612
Diluted net income per share	$	1.17		$	0.80
Shares used to compute diluted net income per share	499,433			500,861

See accompanying notes to condensed consolidated financial statements.

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ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(In thousands)

(Unaudited)



	Three Months Ended
	March 2, 2018			March 3, 2017
	Increase/(Decrease)
Net income	$	583,076		$	398,446
Other comprehensive income (loss), net of taxes:
Available-for-sale securities:
Unrealized gains / losses on available-for-sale securities	(23,150		)	1,024
Reclassification adjustment for recognized gains / losses on available-for-sale securities	121			(160		)
Net increase (decrease) from available-for-sale securities	(23,029		)	864
Derivatives designated as hedging instruments:
Unrealized gains / losses on derivative instruments	(1,336		)	6,709
Reclassification adjustment for recognized gains / losses on derivative instruments	(2,139		)	(18,184		)
Net increase (decrease) from derivatives designated as hedging instruments	(3,475		)	(11,475		)
Foreign currency translation adjustments	28,386			(1,196		)
Other comprehensive income (loss), net of taxes	1,882			(11,807		)
Total comprehensive income, net of taxes	$	584,958		$	386,639

See accompanying notes to condensed consolidated financial statements.

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ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



	Three Months Ended
	March 2, 2018			March 3, 2017
Cash flows from operating activities:
Net income	$	583,076		$	398,446
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion	76,522			80,809
Stock-based compensation	130,488			98,310
Deferred income taxes	(431,494		)	60,315
Unrealized losses (gains) on investments, net	(929		)	(1,021		)
Other non-cash items	1,457			115
Changes in operating assets and liabilities, net of acquired assets and assumed liabilities:
Trade receivables, net	154,398			184,250
Prepaid expenses and other current assets	(64,953		)	(10,758		)
Trade payables	17,552			32,816
Accrued expenses	(65,470		)	(92,105		)
Income taxes payable	511,292			(61,639		)
Deferred revenue	77,662			40,832
Net cash provided by operating activities	989,601			730,370
Cash flows from investing activities:
Purchases of short-term investments	(332,105		)	(476,014		)
Maturities of short-term investments	153,885			219,091
Proceeds from sales of short-term investments	186,114			426,243
Acquisitions, net of cash acquired	—			(459,626		)
Purchases of property and equipment	(95,142		)	(30,903		)
Purchases of long-term investments and other assets	(9,391		)	(18,218		)
Proceeds from sale of long-term investments and other assets	2,877			545
Net cash used for investing activities	(93,762		)	(338,882		)
Cash flows from financing activities:
Purchases of treasury stock	(300,000		)	(200,000		)
Proceeds from reissuance of treasury stock	64,384			51,787
Taxes paid related to net share settlement of equity awards	(305,353		)	(183,014		)
Repayment of capital lease obligations	(304		)	(268		)
Net cash used for financing activities	(541,273		)	(331,495		)
Effect of foreign currency exchange rates on cash and cash equivalents	6,343			(2,412		)
Net increase in cash and cash equivalents	360,909			57,581
Cash and cash equivalents at beginning of period	2,306,072			1,011,315
Cash and cash equivalents at end of period	$	2,666,981		$	1,068,896
Supplemental disclosures:
Cash paid for income taxes, net of refunds	$	31,107		$	27,254
Cash paid for interest	$	26,410		$	24,888
Non-cash investing activities:
Issuance of common stock and stock awards assumed in business acquisitions	$	—		$	10,348

See accompanying notes to condensed consolidated financial statements.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

We have prepared the accompanying unaudited condensed consolidated financial statements pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (the “SEC”). Pursuant to these rules and regulations, we have condensed or omitted certain information and footnote disclosures we normally include in our annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In management’s opinion, we have made all adjustments (consisting only of normal, recurring adjustments, except as otherwise indicated) necessary to fairly present our financial position, results of operations and cash flows. Our interim period operating results do not necessarily indicate the results that may be expected for any other interim period or for the full fiscal year. These financial statements and accompanying notes should be read in conjunction with the consolidated financial statements and notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 1, 2017 on file with the SEC (our “Annual Report”).

Recently Adopted Accounting Guidance

On January 26, 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2017-14, Simplifying the Test for Goodwill Impairment, which eliminated step two from the goodwill impairment test. In assessing impairment of goodwill, if it is concluded that it is more likely than not that the carrying amount of a reportable segment exceeds its fair value during the qualitative assessment, a one-step goodwill impairment test will be performed. If it is concluded during the quantitative test that the carrying amount of a reportable segment exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reportable segment. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted.

In the first quarter of 2018, we early adopted ASU 2017-04. We will apply the provisions of this standard during our annual goodwill impairment test which we perform during the second quarter of our fiscal year. We do not expect the standard to have a significant impact to our goodwill impairment test.

Significant Accounting Policies

There have been no other material changes to our significant accounting policies during the three months ended March 2, 2018, as compared to the significant accounting policies described in our Annual Report.

Recent Accounting Pronouncements Not Yet Effective

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The updated standard will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either the full retrospective or modified retrospective transition method. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers: Deferral of the Effective Date, which deferred the effective date of the new revenue standard for periods beginning after December 15, 2016 to December 15, 2017, with early adoption permitted but not earlier than the original effective date. Accordingly, the updated standard is effective for us in the first quarter of fiscal 2019. We expect to adopt this updated standard in the first quarter of fiscal 2019 on a modified retrospective basis. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

While we are continuing to assess all potential impacts of the new standard, we currently believe that the most significant impact relates to our accounting for arrangements that include on-premise term-based software licenses bundled with maintenance and support. Under current GAAP, the revenue attributable to these software licenses is recognized ratably over the term of the arrangement because VSOE does not exist for the undelivered maintenance and support element as it is not sold separately. The requirement to have VSOE for undelivered elements to enable the separation of revenue for the delivered software licenses is eliminated under the new standard. Accordingly, under the new standard we will be required to recognize as revenue a portion of the arrangement fee upon delivery of the software licenses. We expect revenue related to our professional services and cloud offerings, including Creative Cloud and Document Cloud for business enterprises, individuals and teams, to remain substantially unchanged. When sold with cloud-enabled services, Creative Cloud and Document Cloud require a significant level of integration and interdependency with software and the individual components are not considered distinct. Revenue for these offerings will continue to be recognized over the period in which the cloud services are provided. Under current GAAP, we expense costs related

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

to the acquisition of revenue-generating contracts as incurred. Under the new standard, we will be required to capitalize certain costs incremental to contract acquisition and amortize them over the expected period of benefit. Due to the complexity of certain of our contracts, the actual accounting treatment required under the new standard for these arrangements may be dependent on contract-specific terms and therefore may vary in some instances.

On February 24, 2016, the FASB issued ASU No. 2016-02, Leases, requiring lessees to recognize a right-of-use asset and a lease liability on the balance sheet for all leases with the exception of short-term leases with a lease term of twelve months or less. For lessees, leases will continue to be classified as either operating or finance leases in the income statement. Lessor accounting is similar to the current model but updated to align with certain changes to the lessee model. Lessors will continue to classify leases as operating, direct financing or sales-type leases. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition and requires application of the new guidance at the beginning of the earliest comparative period presented. The updated standard is effective for us beginning in the first quarter of fiscal 2020 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

On August 28, 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging, requiring expanded hedge accounting for both non-financial and financial risk components and refining the measurement of hedge results to better reflect an entity's hedging strategies. The updated standard also amends the presentation and disclosure requirements and changes how entities assess hedge effectiveness. The effective date of the new standard for public companies is for fiscal years beginning after December 15, 2018 and interim periods within those fiscal years. Early adoption is permitted. The new standard must be adopted using a modified retrospective transition with a cumulative effect adjustment recorded to opening retained earnings as of the initial adoption date. The updated standard is effective for us beginning in the first quarter of fiscal 2020 and we do not plan to early adopt. We are currently evaluating the effect that the updated standard will have on our condensed consolidated financial statements and related disclosures.

With the exception of the new standards discussed above, there have been no other recent accounting pronouncements or changes in accounting pronouncements during the three months ended March 2, 2018, as compared to the recent accounting pronouncements described in our Annual Report, that are of significance or potential significance to us.

NOTE 2. ACQUISITIONS

On December 19, 2016, we completed our acquisition of TubeMogul, a publicly held video advertising platform company. Under the acquisition method of accounting, the total purchase price was allocated to TubeMogul’s net tangible and intangible assets based upon their estimated fair values as of December 19, 2016. The total final purchase price for TubeMogul was $560.8 million of which $348.4 million, was allocated to goodwill that was non-deductible for tax purposes, $113.1 million to identifiable intangible assets and $99.3 million to net assets acquired.

Proforma financial information has not been presented for this acquisition as the impact to our condensed consolidated financial statements was not material.

NOTE 3. CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS

Cash equivalents consist of instruments with remaining maturities of three months or less at the date of purchase. We classify all of our cash equivalents and short-term investments as “available-for-sale.” In general, these investments are free of trading restrictions. We carry these investments at fair value, based on quoted market prices or other readily available market information. Unrealized gains and losses, net of taxes, are included in accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our condensed consolidated balance sheets. Gains and losses are recognized when realized in our condensed consolidated statements of income. When we have determined that an other-than-temporary decline in fair value has occurred, the amount of the decline that is related to a credit loss is recognized in income. Gains and losses are determined using the specific identification method.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Cash, cash equivalents and short-term investments consisted of the following as of March 2, 2018 (in thousands):



	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Current assets:
Cash	$	336,972	$	—	$	—		$	336,972
Cash equivalents:
Money market mutual funds	2,322,247		—		—			2,322,247
Time deposits	7,762		—		—			7,762
Total cash equivalents	2,330,009		—		—			2,330,009
Total cash and cash equivalents	2,666,981		—		—			2,666,981
Short-term fixed income securities:
Asset-backed securities	92,067		—		(810		)	91,257
Corporate debt securities	2,461,348		797		(29,828		)	2,432,317
Foreign government securities	3,852		—		(55		)	3,797
Municipal securities	19,249		—		(268		)	18,981
U.S. Treasury securities	939,016		7		(4,386		)	934,637
Total short-term investments	3,515,532		804		(35,347		)	3,480,989
Total cash, cash equivalents and short-term investments	$	6,182,513	$	804	$	(35,347	)	$	6,147,970

Cash, cash equivalents and short-term investments consisted of the following as of December 1, 2017 (in thousands):



	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Current assets:
Cash	$	280,488	$	—	$	—		$	280,488
Cash equivalents:
Money market mutual funds	2,006,741		—		—			2,006,741
Time deposits	18,843		—		—			18,843
Total cash equivalents	2,025,584		—		—			2,025,584
Total cash and cash equivalents	2,306,072		—		—			2,306,072
Short-term fixed income securities:
Asset-backed securities	98,403		1		(403		)	98,001
Corporate debt securities	2,461,691		2,694		(10,125		)	2,454,260
Foreign government securities	2,396		—		(8		)	2,388
Municipal securities	21,189		8		(132		)	21,065
U.S. Treasury securities	941,538		2		(3,552		)	937,988
Total short-term investments	3,525,217		2,705		(14,220		)	3,513,702
Total cash, cash equivalents and short-term investments	$	5,831,289	$	2,705	$	(14,220	)	$	5,819,774

See Note 4 for further information regarding the fair value of our financial instruments.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category, that have been in an unrealized loss position for less than twelve months, as of March 2, 2018 and December 1, 2017 (in thousands):



	2018					2017
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Corporate debt securities	$	1,811,370	$	(22,326	)	$	1,338,232	$	(5,459	)
Asset-backed securities	57,439		(495		)	64,618		(193		)
Municipal securities	18,389		(246		)	11,805		(115		)
Foreign government securities	3,796		(55		)	2,388		(8		)
U.S. Treasury securities	592,296		(3,050		)	593,296		(2,087		)
Total	$	2,483,290	$	(26,172	)	$	2,010,339	$	(7,862	)

There were 1,237 securities and 894 securities in an unrealized loss position for less than twelve months at March 2, 2018 and at December 1, 2017, respectively.

The following table summarizes the fair value and gross unrealized losses related to available-for-sale securities, aggregated by investment category, that were in a continuous unrealized loss position for more than twelve months, as of March 2, 2018 and December 1, 2017 (in thousands):



	2018					2017
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Corporate debt securities	$	479,654	$	(7,502	)	$	500,689	$	(4,666	)
Asset-backed securities	33,818		(315		)	32,383		(210		)
Municipal securities	592		(22		)	598		(17		)
U.S. Treasury securities	299,842		(1,336		)	338,950		(1,465		)
Total	$	813,906	$	(9,175	)	$	872,620	$	(6,358	)

There were 342 securities and 360 securities in an unrealized loss position for more than twelve months at March 2, 2018 and at December 1, 2017, respectively.

The following table summarizes the cost and estimated fair value of short-term fixed income securities classified as short-term investments based on stated effective maturities as of March 2, 2018 (in thousands):



	Amortized Cost		Estimated Fair Value
Due within one year	$	1,210,398	$	1,205,298
Due between one and two years	1,099,330		1,088,663
Due between two and three years	856,020		844,181
Due after three years	349,784		342,847
Total	$	3,515,532	$	3,480,989

We review our debt securities classified as short-term investments on a regular basis to evaluate whether or not any security has experienced an other-than-temporary decline in fair value. We consider factors such as the length of time and extent to which the market value has been less than the cost, the financial condition and near-term prospects of the issuer and our intent to sell, or whether it is more likely than not we will be required to sell the investment before recovery of the investment’s amortized cost basis. If we believe that an other-than-temporary decline exists in one of these securities, we write down these investments to fair value. The portion of the write-down related to credit loss would be recorded to interest and other income, net in our condensed

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

consolidated statements of income. Any portion not related to credit loss would be recorded to accumulated other comprehensive income, which is reflected as a separate component of stockholders’ equity in our condensed consolidated balance sheets. During the three months ended March 2, 2018 and March 3, 2017, we did not consider any of our investments to be other-than-temporarily impaired.

NOTE 4. FAIR VALUE MEASUREMENTS

Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis

We measure certain financial assets and liabilities at fair value on a recurring basis. There have been no transfers between fair value measurement levels during the three months ended March 2, 2018.

The fair value of our financial assets and liabilities at March 2, 2018 was determined using the following inputs (in thousands):



	Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash equivalents:
Money market mutual funds	$	2,322,247	$	2,322,247	$	—	$	—
Time deposits	7,762		7,762		—		—
Short-term investments:
Asset-backed securities	91,257		—		91,257		—
Corporate debt securities	2,432,317		—		2,432,317		—
Foreign government securities	3,797		—		3,797		—
Municipal securities	18,981		—		18,981		—
U.S. Treasury securities	934,637		—		934,637		—
Prepaid expenses and other current assets:
Foreign currency derivatives	11,302		—		11,302		—
Other assets:
Deferred compensation plan assets	64,667		2,617		62,050		—
Total assets	$	5,886,967	$	2,332,626	$	3,554,341	$	—



Liabilities:
Accrued expenses:
Foreign currency derivatives	$	2,221	$	—	$	2,221	$	—
Other Liabilities:
Interest rate swap derivatives	8,517		—		8,517		—
Total liabilities	$	10,738	$	—	$	10,738	$	—

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The fair value of our financial assets and liabilities at December 1, 2017 was determined using the following inputs (in thousands):



	Fair Value Measurements at Reporting Date Using
			Quoted Prices in Active Markets for Identical Assets		Significant Other Observable Inputs		Significant Unobservable Inputs
	Total		(Level 1)		(Level 2)		(Level 3)
Assets:
Cash equivalents:
Money market mutual funds	$	2,006,741	$	2,006,741	$	—	$	—
Time deposits	18,843		18,843		—		—
Short-term investments:
Asset-backed securities	98,001		—		98,001		—
Corporate debt securities	2,454,260		—		2,454,260		—
Foreign government securities	2,388		—		2,388		—
Municipal securities	21,065		—		21,065		—
U.S. Treasury securities	937,988		—		937,988		—
Prepaid expenses and other current assets:
Foreign currency derivatives	14,198		—		14,198		—
Other assets:
Deferred compensation plan assets	56,690		2,573		54,117		—
Total assets	$	5,610,174	$	2,028,157	$	3,582,017	$	—



Liabilities:
Accrued expenses:
Foreign currency derivatives	$	1,598	$	—	$	1,598	$	—
Other liabilities:
Interest rate swap derivatives	1,058		—		1,058		—
Total liabilities	$	2,656	$	—	$	2,656	$	—

See Note 3 for further information regarding the fair value of our financial instruments.

Our fixed income available-for-sale debt securities consist of high quality, investment grade securities from diverse issuers with a weighted average credit rating of AA-. We value these securities based on pricing from independent pricing vendors who use matrix pricing valuation techniques including market approach methodologies that model information generated by market transactions involving identical or comparable assets, as well as discounted cash flow methodologies. Inputs include quoted prices in active markets for identical assets or inputs other than quoted prices that are observable either directly or indirectly in determining fair value, including benchmark yields, issuer spreads off benchmark yields, interest rates and U.S. Treasury or swap curves. We therefore classify all of our fixed income available-for-sale securities as Level 2. We perform routine procedures such as comparing prices obtained from multiple independent sources to ensure that appropriate fair values are recorded.

The fair values of our money market mutual funds and time deposits are based on the closing price of these assets as of the reporting date. We classify our money market mutual funds and time deposits as Level 1.

Our Level 2 over-the-counter foreign currency and interest rate swap derivatives are valued using pricing models and discounted cash flow methodologies based on observable foreign exchange and interest rate data at the measurement date.

Our deferred compensation plan assets consist of money market mutual funds and other mutual funds.

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Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

We also have direct investments in privately held companies accounted for under the cost and equity method, which are periodically assessed for other-than-temporary impairment. If we determine that an other-than-temporary impairment has occurred, we write down the investment to its fair value. We estimate fair value of our cost and equity method investments considering available information such as pricing in recent rounds of financing, current cash positions, earnings and cash flow forecasts, recent operational performance and any other readily available market data. For the three months ended March 2, 2018 and March 3, 2017, we determined there were no other-than-temporary impairments of our cost and equity method investments.

The fair value of our senior notes was $1.93 billion as of March 2, 2018, based on observable market prices in less active markets and categorized as Level 2. See Note 13 for further details regarding our debt.

NOTE 5. DERIVATIVES AND HEDGING ACTIVITIES

Hedge Accounting and Hedging Programs

We recognize derivative instruments and hedging activities as either assets or liabilities in our condensed consolidated balance sheets and measure them at fair value. Gains and losses resulting from changes in fair value are accounted for depending on the use of the derivative and whether it is designated and qualifies for hedge accounting.

We evaluate hedge effectiveness at the inception of the hedge prospectively as well as retrospectively, and record any ineffective portion of the hedging instruments in interest and other income (expense), net on our condensed consolidated statements of income. The net gain (loss) recognized in interest and other income (expense), net for cash flow hedges due to hedge ineffectiveness was insignificant for all fiscal years presented. The time value of purchased contracts is recorded in interest and other income (expense), net in our condensed consolidated statements of income.

The bank counterparties to these contracts expose us to credit-related losses in the event of their nonperformance which are largely mitigated with collateral security agreements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. In addition, we enter into master netting arrangements which have the ability to further limit credit-related losses with the same counterparty by permitting net settlement of transactions.

Balance Sheet Hedging—Hedges of Foreign Currency Assets and Liabilities

We also hedge our net recognized foreign currency denominated assets and liabilities with foreign exchange forward contracts to reduce the risk that the value of these assets and liabilities will be adversely affected by changes in exchange rates. These contracts hedge assets and liabilities that are denominated in foreign currencies and are carried at fair value with changes in the fair value recorded to interest and other income (expense), net in our condensed consolidated statements of income. These contracts do not subject us to material balance sheet risk due to exchange rate movements because gains and losses on these derivatives are intended to offset gains and losses on the assets and liabilities being hedged.

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

In countries outside the United States, we transact business in U.S. Dollars and in various other currencies. We may use foreign exchange option contracts or forward contracts to hedge certain cash flow exposures resulting from changes in these foreign currency exchange rates. These foreign exchange contracts, carried at fair value, have maturities of up to twelve months. We enter into these foreign exchange contracts to hedge a portion of our forecasted foreign currency denominated revenue in the normal course of business and accordingly, they are not speculative in nature.

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To receive hedge accounting treatment, all hedging relationships are formally documented at the inception of the hedge, and the hedges must be highly effective in offsetting changes to future cash flows on hedged transactions. We record changes in the intrinsic value of these cash flow hedges in accumulated other comprehensive income (loss) in our condensed consolidated balance sheets, until the forecasted transaction occurs. When the forecasted transaction occurs, we reclassify the related gain or loss on the cash flow hedge to revenue. In the event the underlying forecasted transaction does not occur, or it becomes probable that it will not occur, we reclassify the gain or loss on the related cash flow hedge from accumulated other comprehensive income (loss) to interest and other income (expense), net in our condensed consolidated statements of income at that time. If we do not elect hedge accounting, or the contract does not qualify for hedge accounting treatment, the changes in fair value from period to period are recorded in interest and other income (expense), net in our condensed consolidated statements of income.

Fair Value Hedging - Hedges of Interest Rate Risk

In fiscal 2014, we entered into interest rate swaps designated as fair value hedges related to our $900 million of 4.75% fixed interest rate senior notes due February 1, 2020. In effect, the interest rate swaps convert the fixed interest rate on these senior notes to a floating interest rate based on LIBOR. Under the terms of the swaps, we will pay monthly interest at the one-month LIBOR interest rate plus a fixed number of basis points on the $900 million notional amount through February 1, 2020. In exchange, we will receive 4.75% fixed rate interest from the swap counterparties. See Note 13 for further details regarding our debt.

The interest rate swaps are accounted for as fair value hedges and substantially offset the changes in fair value of the hedged portion of the underlying debt that are attributable to the changes in market risk. Therefore, the gains and losses related to changes in the fair value of the interest rate swaps are included in interest and other income (expense), net in our condensed consolidated statements of income. The fair value of the interest rate swaps is reflected in other liabilities or other assets in our condensed consolidated balance sheets.

The fair value of derivative instruments on our condensed consolidated balance sheets as of March 2, 2018 and December 1, 2017 were as follows (in thousands):



	2018				2017
	Fair Value Asset Derivatives		Fair Value Liability Derivatives		Fair Value Asset Derivatives		Fair Value Liability Derivatives
Derivatives designated as hedging instruments:
Foreign exchange option contracts^{(1) (2)}	$	9,668	$	—	$	12,918	$	—
Interest rate swap ⁽³⁾	—		8,517		—		1,058
Derivatives not designated as hedging instruments:
Foreign exchange forward contracts ⁽¹⁾	1,634		2,221		1,280		1,598
Total derivatives	$	11,302	$	10,738	$	14,198	$	2,656

^{_________________________________________}


⁽¹⁾	Included in prepaid expenses and other current assets and accrued expenses for asset derivatives and liability derivatives, respectively, on our condensed consolidated balance sheets.


⁽²⁾	Hedging effectiveness expected to be recognized into income within the next twelve months.


⁽³⁾	Included in other liabilities on our condensed consolidated balance sheets.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The effect of foreign currency derivative instruments designated as cash flow hedges and of foreign currency derivative instruments not designated as hedges in our condensed consolidated statements of income for the three months ended March 2, 2018 and March 3, 2017 was as follows (in thousands):



	2018						2017
	Foreign Exchange Option Contracts			Foreign Exchange Forward Contracts			Foreign Exchange Option Contracts			Foreign Exchange Forward Contracts
Derivatives in cash flow hedging relationships:
Net gain (loss) recognized in OCI, net of tax⁽¹⁾	$	(1,336	)	$	—		$	6,709		$	—
Net gain (loss) reclassified from accumulated OCI into income, net of tax⁽²⁾	$	1,022		$	—		$	18,309		$	—
Net gain (loss) recognized in income⁽³⁾	$	(10,326	)	$	—		$	(6,037	)	$	—
Derivatives not designated as hedging relationships:
Net gain (loss) recognized in income⁽⁴⁾	$	—		$	(3,661	)	$	—		$	1,088

^{_________________________________________}


⁽¹⁾	Net change in the fair value of the effective portion classified in other comprehensive income (“OCI”).


⁽²⁾	Effective portion classified as revenue.


⁽³⁾	Ineffective portion and amount excluded from effectiveness testing classified in interest and other income (expense), net.


⁽⁴⁾	Classified in interest and other income (expense), net.

NOTE 6. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Goodwill as of March 2, 2018 and December 1, 2017 was $5.84 billion and $5.82 billion, respectively. The increase was due to foreign currency translation adjustments during the three months ended March 2, 2018.

Purchased and other intangible assets subject to amortization as of March 2, 2018 and December 1, 2017 were as follows (in thousands):



	2018							2017
	Cost		Accumulated Amortization			Net		Cost		Accumulated Amortization			Net
Purchased technology	$	194,099	$	(90,103	)	$	103,996	$	223,252	$	(110,433	)	$	112,819
Customer contracts and relationships	$	549,227	$	(345,797	)	$	203,430	$	577,484	$	(356,613	)	$	220,871
Trademarks	35,255		(16,247		)	19,008		76,255		(56,094		)	20,161
Acquired rights to use technology	65,285		(50,488		)	14,797		71,130		(54,223		)	16,907
Localization	620		(329		)	291		603		(170		)	433
Other intangibles	38,019		(25,801		)	12,218		38,693		(24,226		)	14,467
Total other intangible assets	$	688,406	$	(438,662	)	$	249,744	$	764,165	$	(491,326	)	$	272,839
Purchased and other intangible assets, net	$	882,505	$	(528,765	)	$	353,740	$	987,417	$	(601,759	)	$	385,658

Amortization expense related to purchased and other intangible assets was $33.9 million and $38.1 million for the three months ended March 2, 2018 and March 3, 2017, respectively. Of these amounts, $16.7 million and $18.7 million were included in cost of sales for the three months ended March 2, 2018 and March 3, 2017, respectively.

During the three months ended March 2, 2018, certain purchased intangibles associated with our acquisitions of Omniture, Inc. and Day Software Holding AG became fully amortized and were removed from the condensed consolidated balance sheets.

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(Unaudited)

As of March 2, 2018, we expect amortization expense in future periods to be as follows (in thousands):



Fiscal Year	Purchased Technology		Other Intangible Assets
Remainder of 2018	$	27,988	$	73,208
2019	34,029		70,156
2020	31,737		39,880
2021	9,125		17,474
2022	1,117		14,467
Thereafter	—		34,559
Total expected amortization expense	$	103,996	$	249,744

NOTE 7. ACCRUED EXPENSES

Accrued expenses as of March 2, 2018 and December 1, 2017 consisted of the following (in thousands):



	2018		2017
Accrued compensation and benefits	$	349,727	$	417,742
Accrued media costs	109,243		134,525
Sales and marketing allowances	50,806		47,389
Accrued corporate marketing	75,642		72,087
Taxes payable	48,236		49,550
Royalties payable	45,482		46,411
Accrued interest expense	6,984		25,594
Other	224,924		200,475
Accrued expenses	$	911,044	$	993,773

Accrued media costs primarily relate to our advertising platform offerings from TubeMogul, which are part of the Advertising Cloud. We accrue for media costs related to impressions purchased from third-party ad inventory sources. Other primarily includes general corporate accruals for local and regional expenses. Other is also comprised of deferred rent related to office locations with rent escalations and foreign currency liability derivatives.

NOTE 8. INCOME TAXES

On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law, which significantly changes existing U.S. tax law and includes many provisions applicable to us, such as reducing the U.S. federal statutory tax rate, imposing a one-time transition tax on deemed repatriation of deferred foreign income, and adopting a territorial tax system. The Tax Act reduces the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. For fiscal 2018, our blended U.S. federal statutory tax rate is 22.2%. This is the result of using the tax rate of 35% for the first month of fiscal 2018 and the reduced tax rate of 21% for the remaining eleven months of fiscal 2018. The Tax Act also requires us to incur a one-time transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income, in each case reduced by certain foreign tax credits. The Tax Act also includes a provision to tax global intangible low-taxed income of foreign subsidiaries, a special tax deduction for foreign-derived intangible income, and a base erosion anti-abuse tax measure that may tax certain payments between a U.S. corporation and its subsidiaries. These additional provisions of the Tax Act will be effective for us beginning December 1, 2018.

The Tax Act is effective in the first quarter of our fiscal 2018. As of March 2, 2018, we have not completed our accounting for the tax effects of the Tax Act. During the quarter, we recorded a provisional tax charge based on reasonable estimates for those tax effects using the current available information and technical guidance on the interpretations of the Tax Act. In order to complete our accounting for the impact of the Tax Act, we continue to obtain, analyze and interpret additional guidance as such guidance

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(Unaudited)

becomes available from the U.S. Treasury Department, the Internal Revenue Service (“IRS”), state taxing jurisdictions, the FASB, and other standard-setting and regulatory bodies. New guidance or interpretations may materially impact our provision for income taxes in future periods. Additional information that is needed to complete the analysis but is currently unavailable includes, but is not limited to, the amount of earnings of certain subsidiaries as well as the amount of foreign taxes paid on such earnings for our fiscal 2018, the final determination of certain net deferred tax assets subject to remeasurement and when the related temporary differences will be settled or realized, and the tax treatment of such provisions of the Tax Act by various state tax authorities. In addition, we do not currently have sufficient information and guidance to determine the impact of certain changes to the taxation of our foreign earnings that will become effective for us in fiscal 2019. The provisional accounting impacts may change in future reporting periods until our accounting analysis is finalized, which will occur no later than one year from the enactment date, as permitted by SEC Staff Accounting Bulletin 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act.

As a result of the reduction in the federal corporate tax rate, we remeasured our deferred taxes as of the date of enactment of the Tax Act resulting in a provisional tax charge of $10 million based on the tax rate that is expected to apply when such deferred taxes are settled or realized in future periods. We have not yet completed our accounting for the measurement of deferred taxes. To calculate the remeasurement of deferred taxes, we estimated when the existing deferred taxes will be settled or realized. The remeasurement of deferred taxes included in our financial statements will be subject to further revisions if our current estimates are different from our actual future operating results.

As part of the adoption of a new territorial tax system we recorded a provisional transition tax expense of $118 million on deferred foreign earnings, which is comprised of $86 million for fiscal 2018 plus other ancillary effects recorded in the first fiscal quarter, long term income taxes payable of $533 million, and a reduction in our deferred tax liability of $415 million. To calculate the transition tax, we estimated our deferred foreign income for fiscal 2017 and 2018 because these tax returns are not complete or due. The fiscal 2017 and fiscal 2018 taxable income will be known once the respective tax returns are completed and filed. In addition, U.S. and foreign audit settlements may significantly impact the estimated transition tax. The impact of the U.S. and foreign audits on the transition tax will be known as the audits are concluded. We currently intend to elect to pay the federal transition tax over a period of eight years as permitted by the Tax Act.

Certain international provisions introduced in the Tax Act will be effective for us in fiscal 2019. We need additional information to complete our analysis on whether to adopt an accounting policy to account for the tax effects of these provisions in the period that it is subject to such tax, or to provide deferred taxes for book and tax basis differences that upon reversal may be subject to these taxes. Accordingly, we have not recorded any tax with respect to these provisions in the three months ended March 2, 2018. We will make an accounting policy election and complete the required accounting no later than the first quarter of fiscal 2019.

NOTE 9. STOCK-BASED COMPENSATION

Summary of Restricted Stock Units

Restricted stock unit activity for the three months ended March 2, 2018 and the fiscal year ended December 1, 2017 was as follows (in thousands):



	2018		2017
Beginning outstanding balance	9,304		8,316
Awarded	2,996		5,018
Released	(2,950	)	(3,859	)
Forfeited	(155	)	(766	)
Increase due to acquisition	—		595
Ending outstanding balance	9,195		9,304

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Information regarding restricted stock units outstanding at March 2, 2018 and March 3, 2017 is summarized below:



	Number of Shares (thousands)	Weighted Average Remaining Contractual Life (years)	Aggregate Intrinsic Value^(*) (millions)
2018
Restricted stock units outstanding	9,195	1.52	$	1,928.9
Restricted stock units vested and expected to vest	8,259	1.47	$	1,732.6
2017
Restricted stock units outstanding	9,822	1.59	$	1,002.3
Restricted stock units vested and expected to vest	8,646	1.53	$	882.2

^{_________________________________________}


^(*)	The intrinsic value is calculated as the market value as of the end of the fiscal period. As reported by the NASDAQ Global Select Market, the market values as of March 2, 2018 and March 3, 2017 were $209.79 and $120.04, respectively.

Summary of Performance Shares

Our Performance Share Programs aim to help focus key employees on building stockholder value, provide significant award potential for achieving outstanding Company performance and enhance the ability of the Company to attract and retain highly talented and competent individuals. The Executive Compensation Committee of our Board of Directors approves the terms of each of our Performance Share Programs, including the award calculation methodology, under the terms of our 2003 Equity Incentive Plan. Shares may be earned based on the achievement of an objective relative total stockholder return measured over a three-year performance period. Performance share awards will be awarded and fully vest upon the Executive Compensation Committee's certification of the level of achievement following the three-year anniversary of each grant date. Program participants generally have the ability to receive up to 200% of the target number of shares originally granted.

In the first quarter of fiscal 2018, the Executive Compensation Committee approved the 2018 Performance Share Program.

In the first quarter of fiscal 2018, the Executive Compensation Committee also certified the actual performance achievement of participants in the 2015 Performance Share Program. Actual performance resulted in participants achieving 200% of target or approximately 1.0 million shares. The shares granted and achieved under the 2015 Performance Share Program fully vested on the three-year anniversary of the grant on January 24, 2018, if not forfeited.

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

As of March 2, 2018, the shares awarded under our 2018, 2017 and 2016 Performance Share Programs are yet to be achieved.

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(Unaudited)

The following table sets forth the summary of performance share activity under our Performance Share Programs for the three months ended March 2, 2018 and the fiscal year ended December 1, 2017 (in thousands):



	2018					2017
	Shares Granted			Maximum Shares Eligible to Receive		Shares Granted			Maximum Shares Eligible to Receive
Beginning outstanding balance	1,534			3,068		1,630			3,261
Awarded	837		⁽¹⁾	628		1,082		⁽²⁾	1,040
Achieved	(1,050	)		(1,054	)	(1,135	)		(1,147	)
Forfeited	(35	)		(70	)	(43	)		(86	)
Ending outstanding balance	1,286			2,572		1,534			3,068

^{_________________________________________}


⁽¹⁾	Included in the 0.8 million shares awarded during the three months ended March 2, 2018 were 0.5 million shares awarded for the final achievement of the 2015 Performance Share program. The remaining awarded shares were for the 2018 Performance Share Program.


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

Summary of Employee Stock Purchase Plan Shares

The expected life of the ESPP shares is the average of the remaining purchase periods under each offering period. The assumptions used to value employee stock purchase rights during the three months ended March 2, 2018 and March 3, 2017 were as follows:



	Three Months
	2018	2017
Expected life (in years)	0.5 - 2.0	0.5 - 2.0
Volatility	26% - 27%	22% - 25%
Risk free interest rate	1.54% - 1.89%	0.62% - 1.2%

Employees purchased 0.7 million shares at an average price of $91.74 and 0.7 million shares at an average price of $71.72 for the three months ended March 2, 2018 and March 3, 2017, respectively. The intrinsic value of shares purchased during the three months ended March 2, 2018 and March 3, 2017 was $54.3 million and $20.4 million, respectively. The intrinsic value is calculated as the difference between the market value on the date of purchase and the purchase price of the shares.

Summary of Stock Options

The Executive Compensation Committee of Adobe’s Board of Directors eliminated the use of stock option grants for all employees and the Board of Directors effective fiscal 2012 and fiscal 2014, respectively. As of March 2, 2018 and December 1, 2017, we had 0.1 million and 0.3 million stock options outstanding, respectively.

Compensation Costs

As of March 2, 2018, there was $1.19 billion 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 2.2 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.

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(Unaudited)

Total stock-based compensation costs included in our condensed consolidated statements of income for the three months ended March 2, 2018 and March 3, 2017 were as follows (in thousands):



	2018				2017
Income Statement Classifications	Option Grants and Stock Purchase Rights		Restricted Stock Units and Performance Share Awards		Option Grants and Stock Purchase Rights		Restricted Stock Units and Performance Share Awards
Cost of revenue—subscription	$	768	$	3,944	$	393	$	2,161
Cost of revenue—services and support	2,016		2,986		1,723		3,065
Research and development	5,349		54,072		4,032		33,094
Sales and marketing	5,320		38,848		4,388		32,465
General and administrative	1,480		20,742		1,230		18,316
Total	$	14,933	$	120,592	$	11,766	$	89,101

NOTE 10. STOCKHOLDERS’ EQUITY

Retained Earnings

The changes in retained earnings for the three months ended March 2, 2018 were as follows (in thousands):



Balance as of December 1, 2017	$	9,573,870
Net income	583,076
Reissuance of treasury stock	(326,229		)
Adjustments to equity as a result of the Tax Act	(318		)
Balance as of March 2, 2018	$	9,830,399

We account for treasury stock under the cost method. When treasury stock is re-issued at a price higher than its cost, the difference is recorded as a component of additional paid-in-capital in our condensed consolidated balance sheets. When treasury stock is re-issued at a price lower than its cost, the difference is recorded as a component of additional paid-in-capital to the extent that there are treasury stock gains to offset the losses. If there are no treasury stock gains in additional paid-in-capital, the losses upon re-issuance of treasury stock are recorded as a reduction of retained earnings in our condensed consolidated balance sheets.

See Note 8 for more detailed information regarding impacts of the Tax Act.

The components of accumulated other comprehensive income (loss) and activity, net of related taxes, as of March 2, 2018 were as follows (in thousands):



	December 1, 2017			Increase / Decrease			Reclassification Adjustments				March 2, 2018
Net unrealized gains / losses on available-for-sale securities:
Unrealized gains on available-for-sale securities	$	2,704		$	(1,717	)	$	(184	)		$	803
Unrealized losses on available-for-sale securities	(14,220		)	(21,433		)	305				(35,348		)
Total net unrealized gains / losses on available-for-sale securities	(11,516		)	(23,150		)	121			⁽¹⁾	(34,545		)
Net unrealized gains / losses on derivative instruments designated as hedging instruments	(3,367		)	(1,336		)	(2,139		)	⁽²⁾	(6,842		)
Cumulative foreign currency translation adjustments	(96,938		)	28,386			—				(68,552		)
Total accumulated other comprehensive income (loss), net of taxes	$	(111,821	)	$	3,900		$	(2,018	)		$	(109,939	)

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(Unaudited)

^{_________________________________________}


⁽¹⁾	Reclassification adjustments for gains / losses on available-for-sale securities are classified in interest and other income (expense), net.


⁽²⁾	Reclassification adjustments for gains / losses on derivative instruments are classified in revenue.

The following table sets forth the taxes related to each component of other comprehensive income for the three months ended March 2, 2018 and March 3, 2017 (in thousands):



	Three Months
	2018			2017
Available-for-sale securities:
Unrealized gains / losses	$	—		$	248
Reclassification adjustments	—			(109		)
Subtotal available-for-sale securities	—			139
Derivatives designated as hedging instruments:
Unrealized gains / losses on derivative instruments⁽¹⁾	—			—
Reclassification adjustments⁽¹⁾	(1,526		)	(284		)
Subtotal derivatives designated as hedging instruments	(1,526		)	(284		)
Foreign currency translation adjustments	(1,742		)	386
Total taxes, other comprehensive income	$	(3,268	)	$	241

^{_________________________________________}


⁽¹⁾	Taxes related to derivative instruments other than the interest rate lock agreement were zero based on the tax jurisdiction where these derivative instruments were executed.

Stock Repurchase Program

To facilitate our stock repurchase program, designed to return value to our stockholders and minimize dilution from stock issuances, we may repurchase shares in the open market or enter into structured repurchase agreements with third parties. In January 2017, our Board of Directors approved a new stock repurchase program granting us authority to repurchase up to $2.5 billion in common stock through the end of fiscal 2019. The new stock repurchase program approved by our Board of Directors is similar to our previous stock repurchase programs.

During the three months ended March 2, 2018 and March 3, 2017, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $300 million and $200 million, respectively. We enter into these agreements in order to take advantage of repurchasing shares at a guaranteed discount to the Volume Weighted Average Price (“VWAP”) of our common stock over a specified period of time. We only enter into such transactions when the discount that we receive is higher than the foregone return on our cash prepayments to the financial institutions. There were no explicit commissions or fees on these structured repurchases. Under the terms of the agreements, there is no requirement for the financial institutions to return any portion of the prepayment to us.

The financial institutions agree to deliver shares to us at monthly intervals during the contract term. The parameters used to calculate the number of shares deliverable are: the total notional amount of the contract, the number of trading days in the contract, the number of trading days in the interval and the average VWAP of our stock during the interval less the agreed upon discount. During the three months ended March 2, 2018, we repurchased approximately 1.6 million shares at an average price of $185.13 through structured repurchase agreements entered into during fiscal 2017 and the three months ended March 2, 2018. During the three months ended March 3, 2017 we repurchased approximately 2.2 million shares at an average price of $107.54 through structured repurchase agreements entered into during fiscal 2016 and the three months ended March 3, 2017.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

For the three months ended March 2, 2018, the prepayments were classified as treasury stock on our condensed consolidated balance sheets at the payment date, though only shares physically delivered to us by March 2, 2018 were excluded from the computation of earnings per share. As of March 2, 2018, $100.3 million of prepayment remained under this agreement.

Subsequent to March 2, 2018, as part of the $2.5 billion stock repurchase authority approved in January 2017, we entered into a structured stock repurchase agreement with a large financial institution whereupon we provided them with a prepayment of $700 million. This amount will be classified as treasury stock on our condensed consolidated balance sheets. Upon completion of the $700 million stock repurchase agreement, $900 million remains under our current authority.

NOTE 11. NET INCOME PER SHARE

The following table sets forth the computation of basic and diluted net income per share for the three months ended March 2, 2018 and March 3, 2017 (in thousands, except per share data):



	Three Months
	2018		2017
Net income	$	583,076	$	398,446
Shares used to compute basic net income per share	492,061		494,612
Dilutive potential common shares:
Unvested restricted stock units and performance share awards	7,191		5,867
Stock options	181		382
Shares used to compute diluted net income per share	499,433		500,861
Basic net income per share	$	1.18	$	0.81
Diluted net income per share	$	1.17	$	0.80

NOTE 12. COMMITMENTS AND CONTINGENCIES

Royalties

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

Indemnifications

In the ordinary course of business, we provide indemnifications of varying scope to customers and channel partners against claims of intellectual property infringement made by third parties arising from the use of our products and from time to time, we are subject to claims by our customers under these indemnification provisions. Historically, costs related to these indemnification provisions have not been significant and we are unable to estimate the maximum potential impact of these indemnification provisions on our future results of operations.

To the extent permitted under Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is or was serving at our request in such capacity. The indemnification period covers all pertinent events and occurrences during the officer’s or director’s lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have director and officer insurance coverage that reduces our exposure and enables us to recover a portion of any future amounts paid. We believe the estimated fair value of these indemnification agreements in excess of applicable insurance coverage is minimal.

Legal Proceedings

In connection with disputes relating to the validity or alleged infringement of third-party intellectual property rights, including patent rights, we have been, are currently and may in the future be subject to claims, negotiations or complex, protracted litigation. Intellectual property disputes and litigation may be very costly and can be disruptive to our business operations by diverting the attention and energies of management and key technical personnel. Although we have successfully defended or resolved past

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

litigation and disputes, we may not prevail in any ongoing or future litigation and disputes. Third-party intellectual property disputes could subject us to significant liabilities, require us to enter into royalty and licensing arrangements on unfavorable terms, prevent us from licensing certain of our products or offering certain of our services, subject us to injunctions restricting our sale of products or services, cause severe disruptions to our operations or the markets in which we compete, or require us to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements and service agreements.

In addition to intellectual property disputes, we are subject to legal proceedings, claims and investigations in the ordinary course of business, including claims relating to commercial, employment and other matters. Some of these disputes and legal proceedings may include speculative claims for substantial or indeterminate amounts of damages. We consider all claims on a quarterly basis in accordance with GAAP and based on known facts assess whether potential losses are considered reasonably possible, probable and estimable. Based upon this assessment, we then evaluate disclosure requirements and whether to accrue for such claims in our financial statements. This determination is then reviewed and discussed with our Audit Committee and our independent registered public accounting firm.

We make a provision for a liability when it is both probable that a liability has been incurred and the amount of the loss can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impacts of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case. Unless otherwise specifically disclosed in this note, we have determined that no provision for liability nor disclosure is required related to any claim against us because: (a) there is not a reasonable possibility that a loss exceeding amounts already recognized (if any) may be incurred with respect to such claim; (b) a reasonably possible loss or range of loss cannot be estimated; or (c) such estimate is immaterial.

All legal costs associated with litigation are expensed as incurred. Litigation is inherently unpredictable. However, we believe that we have valid defenses with respect to the legal matters pending against us. It is possible, nevertheless, that our consolidated financial position, cash flows or results of operations could be negatively affected by an unfavorable resolution of one or more of such proceedings, claims or investigations.

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

NOTE 13. DEBT

Notes

In February 2010, we issued $900 million of 4.75% senior notes due February 1, 2020 (the “2020 Notes”). Our proceeds were $900 million and were net of an issuance discount of $5.5 million. In addition, we incurred issuance costs of $6.4 million. Both the discount and issuance costs are being amortized to interest expense over the term of the 2020 Notes using the effective interest method. The effective interest rate including the discount and issuance costs is 4.92%. Interest is payable semi-annually, in arrears, on February 1 and August 1, and commenced on August 1, 2010.

In June 2014, we entered into interest rate swaps with a total notional amount of $900 million designated as a fair value hedge related to our 2020 Notes. The interest rate swaps effectively convert the fixed interest rate on our 2020 Notes to a floating interest rate based on LIBOR. Under the terms of the swap, we will pay monthly interest at the one-month LIBOR interest rate plus a fixed number of basis points on the $900 million notional amount. In exchange, we will receive 4.75% fixed rate interest from the swap counterparties. See Note 5 for further details regarding our interest rate swap derivatives.

In January 2015, we issued $1 billion of 3.25% senior notes due February 1, 2025 (the “2025 Notes”). Our proceeds were approximately $989.3 million which is net of an issuance discount of $10.7 million. In addition, we incurred issuance costs of $7.9 million. Both the discount and issuance costs are being amortized to interest expense over the term of the 2025 Notes using the effective interest method. The effective interest rate including the discount, issuance costs and interest rate agreement is 3.67%. Interest is payable semi-annually, in arrears on February 1 and August 1, and commenced on August 1, 2015.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

As of March 2, 2018, our outstanding notes payable consist of the 2020 Notes and 2025 Notes (the “Notes”) with a total carrying value of $1.87 billion which includes the fair value of the interest rate swap and is net of debt issuance costs. Based on quoted prices in inactive markets, the total fair value of the Notes was $1.93 billion as of March 2, 2018 and excludes the effect of the fair value hedge of the 2020 Notes for which we entered into interest rate swaps as described above.

The Notes rank equally with our other unsecured and unsubordinated indebtedness. We may redeem the Notes at any time, subject to a make-whole premium. In addition, upon the occurrence of certain change of control triggering events, we may be required to repurchase the Notes, at a price equal to 101% of their principal amount, plus accrued and unpaid interest to the date of repurchase. The Notes also include covenants that limit our ability to grant liens on assets and to enter into sale and leaseback transactions, subject to significant allowances. As of March 2, 2018, we were in compliance with all of the covenants.

In February 2018, we made semi-annual interest payments on our 2020 and 2025 Notes totaling $37.6 million.

Credit Agreement

On March 2, 2012, we entered into a five-year $1 billion senior unsecured revolving credit agreement (the “Credit Agreement”), providing for loans to us and certain of our subsidiaries. Pursuant to the terms of the Credit Agreement, we may, subject to the agreement of the applicable lenders, request up to an additional $500 million in commitments, for a maximum aggregate commitment of $1.5 billion. Loans under the Credit Agreement will bear interest at either (i) LIBOR plus a margin, based on our public debt ratings, ranging from 0.795% and 1.30% or (ii) the base rate, which is defined as the highest of (a) the agent’s prime rate, (b) the federal funds effective rate plus 0.50% or (c) LIBOR plus 1.00% plus a margin, based on our debt ratings, ranging from 0.00% to 0.30%. Commitment fees are payable quarterly at rates between 0.08% and 0.20% per year, also based on our debt ratings. Subject to certain conditions stated in the Credit Agreement, we and any of our subsidiaries designated as additional borrowers may borrow, prepay and re-borrow amounts under the revolving credit facility at any time during the term of the Credit Agreement. On July 27, 2015, we entered into an amendment to further extend the maturity date to July 27, 2020 and reallocated the facility among the syndicate of lenders that are parties to the Credit Agreement.

The Credit Agreement contains customary representations, warranties, affirmative and negative covenants, including a financial covenant, events of default and indemnification provisions in favor of the lenders. The negative covenants include restrictions regarding the incurrence of liens and indebtedness, certain merger and acquisition transactions, dispositions and other matters, all subject to certain exceptions. The financial covenant, based on a quarterly financial test, requires us not to exceed a maximum leverage ratio.

On July 27, 2015, we entered into an amendment to further extend the maturity date to July 27, 2020 and reallocated the facility among the syndicate of lenders that are parties to the Credit Agreement.

The facility will terminate and all amounts owing thereunder will be due and payable on the maturity date unless (a) the commitments are terminated earlier upon the occurrence of certain events, including an event of default, or (b) the maturity date is further extended upon our request, subject to the agreement of the lenders.

As of March 2, 2018, there were no outstanding borrowings under this Credit Agreement and we were in compliance with all covenants.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 14. NON-OPERATING INCOME (EXPENSE)

Non-operating income (expense) for the three months ended March 2, 2018 and March 3, 2017 included the following (in thousands):



	Three Months
	2018			2017
Interest and other income (expense), net:
Interest income	$	22,630		$	14,157
Foreign exchange gains (losses)	(5,889		)	(7,131		)
Realized gains on fixed income investment	184			294
Realized losses on fixed income investment	(305		)	(134		)
Other	52			20
Interest and other income (expense), net	$	16,672		$	7,206
Interest expense	$	(19,899	)	$	(18,130	)
Investment gains (losses), net:
Realized investment gains	$	3,994		$	1,959
Unrealized investment gains	—			598
Unrealized investment losses	(998		)	—
Investment gains (losses), net	$	2,996		$	2,557
Non-operating income (expense), net	$	(231	)	$	(8,367	)

NOTE 15. SEGMENTS

We report segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of our reportable segments.

Our CEO, the chief operating decision maker, reviews revenue and gross margin information for each of our reportable segments, but does not review operating expenses 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 reportable segments.

Effective in fiscal 2018, our business organized into three reportable segments: Digital Media, Digital Experience (formerly Digital Marketing), and Publishing (formerly Print and Publishing). These segments provide our senior management with a comprehensive financial view of our key businesses. Our segments are aligned around our two strategic growth opportunities described above, placing our Publishing business in a third segment that contains some of our mature products and solutions.

Additionally, in the first quarter of fiscal 2018, we moved our legacy enterprise offerings—Adobe Connect web conferencing platform and Adobe LiveCycle, an enterprise document and forms platform—from our Digital Experience segment into Publishing, in order to more closely align our Digital Experience business with the strategic growth opportunity. Our reportable segments at the beginning of fiscal 2018 reflect these changes below.

We have the following reportable segments:

•

Digital Media—Our Digital Media segment provides tools and solutions that enable individuals, small and medium businesses and enterprises to create, publish, promote and monetize their digital content anywhere. Our customers include traditional content creators, web application developers and digital media professionals, as well as their management in marketing departments and agencies, companies and publishers. Our customers also include knowledge workers who create, collaborate and distribute documents.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)


•	Digital Experience—Our Digital Experience segment provides solutions and services for how digital advertising and marketing are created, managed, executed, measured and optimized. Our customers include digital marketers, advertisers, publishers, merchandisers, web analysts, chief marketing officers, chief information officers and chief revenue officers.


•	Publishing—Our Publishing segment addresses market opportunities ranging from the diverse authoring and publishing needs of technical and business publishing to our legacy type and OEM printing businesses. It also includes our web conferencing and document and forms platforms effective the first quarter of fiscal 2018.

Our segment results for the three months ended March 2, 2018 and March 3, 2017 were as follows (dollars in thousands):



	Digital Media			Digital Experience			Publishing			Total
Three months ended March 2, 2018
Revenue	$	1,460,561		$	554,107		$	64,279		$	2,078,947
Cost of revenue	55,469			198,792			4,641			258,902
Gross profit	$	1,405,092		$	355,315		$	59,638		$	1,820,045
Gross profit as a percentage of revenue	96		%	64		%	93		%	88		%
Three months ended March 3, 2017
Revenue	$	1,138,079		$	477,272		$	66,295		$	1,681,646
Cost of revenue	55,052			176,763			5,522			237,337
Gross profit	$	1,083,027		$	300,509		$	60,773		$	1,444,309
Gross profit as a percentage of revenue	95		%	63		%	92		%	86		%

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

The following discussion 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, market opportunities, strategic initiatives, industry positioning, customer acquisition, the amount of recurring revenue and revenue growth. In addition, when used in this report, the words “will,” “expects,” “could,” “would,” “may,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “targets,” “estimates,” “looks for,” “looks to,” “continues” and similar expressions, as well as statements regarding our focus for the future, are generally intended to identify forward-looking statements. Each of the forward-looking statements we make in this report involves 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 of this report. You should carefully review the risks described herein and in other documents we file from time to time with the U.S. Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K for fiscal 2017. 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, except as required by law.

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 products and services used by creative professionals, marketers, knowledge workers, application developers, enterprises and consumers for creating, managing, delivering, measuring, optimizing and engaging with compelling content and experiences across personal computers, devices and media. We market our products and services directly to enterprise customers through our sales force and certain local field offices. We license our products to end users through app stores and our own website at www.adobe.com. We offer many of our products via a Software-as-a-Service (“SaaS”) model or a managed services model (both of which are referred to as hosted or cloud-based) as well as through term subscription and pay-per-use models. We also distribute certain products and services through a network of distributors, value-added resellers (“VARs”), systems integrators (“SIs”), independent software vendors (“ISVs”), retailers, software developers and original equipment manufacturers (“OEMs”). In addition, we license our technology to hardware manufacturers, software developers and service providers for use in their products and solutions. Our products run on personal and server-based computers, as well as on smartphones, tablets and other devices, depending on the product. We have operations in the Americas, Europe, Middle East and Africa (“EMEA”) and Asia-Pacific (“APAC”).

Adobe was originally incorporated in California in October 1983 and was reincorporated in Delaware in May 1997. Our executive offices and principal facilities are located at 345 Park Avenue, San Jose, California 95110-2704. Our telephone number is 408-536-6000 and our website is www.adobe.com. Investors can obtain copies of our SEC filings from this site free of charge, as well as from the SEC website at www.sec.gov. The information posted to our website is not incorporated into this Quarterly Report on Form 10-Q.

OPERATIONS OVERVIEW

For our first quarter of fiscal 2018, we reported strong financial results consistent with the continued execution of our long-term plans for our two strategic growth areas, Digital Media and Digital Experience (formerly Digital Marketing), while continuing to market and license a broad portfolio of products and solutions.

In our Digital Media segment, we are a market leader with Creative Cloud, our subscription-based offering for creating and publishing content and applications. Creative Cloud delivers value through frequent product updates, storage and access to user files stored in the cloud with syncing of files across users’ machines, access to marketplace, social and community-based features with our Adobe Stock and Behance services, app creation capabilities and affordable pricing for cost-sensitive customers.

We offer Creative Cloud for individuals, students, teams and enterprises. We expect Creative Cloud will drive sustained long-term revenue growth through a continued expansion of our customer base by acquiring new users on account of low cost of entry and delivery of additional features and value to Creative Cloud, as well as keeping existing customers current on our latest release. We have also built out a marketplace for Creative Cloud subscribers to enable the delivery and purchase of stock content in our Adobe Stock service. Overall, our strategy with Creative Cloud is designed to enable us to increase our revenue with users, attract more new customers, and grow a recurring and predictable revenue stream that is recognized ratably.

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We continue to implement strategies that will accelerate awareness, consideration and purchase of subscriptions to our Creative Cloud offerings. These strategies include increasing the value Creative Cloud users receive, such as offering new mobile applications, as well as targeted promotions and offers that attract past customers and potential users to try out and ultimately subscribe to Creative Cloud. Because of the shift towards Creative Cloud subscriptions and Enterprise Term License Agreements (“ETLAs”), revenue from perpetual licensing of our Creative products has been immaterial to our business.

We are also a market leader with our Adobe Document Cloud offerings built around our Adobe Acrobat family of products, including Adobe Acrobat Reader DC, and a set of integrated cloud-based document services, including Adobe Sign. Acrobat provides reliable creation and exchange of electronic documents, regardless of platform or application source type. Document Cloud, which we believe enhances the way people manage critical documents at home, in the office and across devices, includes Adobe Acrobat DC and Adobe Sign, and a set of integrated services enabling users to create, review, approve, sign and track documents whether on a desktop or mobile device. Adobe Acrobat DC, with a touch-enabled user interface, is offered both through subscription and perpetual licenses.

Annualized Recurring Revenue (“ARR”) is currently the key performance metric our management uses to assess the health and trajectory of our overall Digital Media segment. ARR should be viewed independently of revenue, deferred revenue and unbilled deferred revenue as ARR is a performance metric and is not intended to be combined with any of these items. We adjust our reported ARR on an annual basis to reflect any material exchange rates changes. Our reported ARR results in fiscal 2018 are based on currency rates set at the start of fiscal 2018 and held constant throughout the year. We calculate ARR as follows:



Creative ARR	Annual Value of Creative Cloud Subscriptions and Services + Annual Digital Publishing Suite Contract Value + Annual Creative ETLA Contract Value
Document Cloud ARR	Annual Value of Document Cloud Subscriptions and Services + Annual Document Cloud ETLA Contract Value
Digital Media ARR	Creative ARR + Document Cloud ARR

Creative ARR exiting the first quarter of fiscal 2018 was $5.07 billion, up from $4.77 billion at the end of fiscal 2017. Document Cloud ARR exiting the first quarter of fiscal 2018 was $647 million, up from $614 million at the end of fiscal 2017. Total Digital Media ARR grew to $5.72 billion at the end of the first quarter of fiscal 2018, up from $5.39 billion at the end of fiscal 2017.

Our success in driving growth in ARR has positively affected our revenue growth. Creative revenue in the first quarter of fiscal 2018 was $1.23 billion, up from $942.2 million in the first quarter of fiscal 2017 and representing 30% year-over-year growth. Document Cloud revenue in the first quarter of fiscal 2018 was $231.0 million, up from $195.9 million in the first quarter of fiscal 2017 as we continue to transition Document Cloud to a subscription-based model. Total Digital Media segment revenue grew to $1.46 billion in the first quarter of fiscal 2018, up from $1.14 billion in the first quarter of fiscal 2017 and representing 28% year-over-year growth.

We are a market leader in the fast-growing category addressed by our Digital Experience segment. Our Digital Experience business provides comprehensive solutions that include analytics, social marketing, targeting, media optimization, digital experience management, cross-channel campaign management, audience management, premium video delivery and monetization. These comprehensive solutions enable marketers to measure, personalize and optimize marketing campaigns and digital experiences across channels for optimal marketing performance.

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Our hierarchy of solutions in the Digital Experience segment, available in our Adobe Experience Cloud, consists of the following cloud offerings:


•	Adobe Marketing Cloud—provides an integrated set of solutions to help marketers differentiate their brands and engage their customers, helping businesses manage, personalize, and orchestrate campaigns and customer journeys; includes Adobe Experience Manager (“AEM”), Adobe Campaign, Adobe Target, Adobe Social and Adobe Primetime.

•

Adobe Analytics Cloud—enables businesses to move from insights to actions in real time by uniquely integrating audiences as the core system of intelligence for the enterprise; makes data available across all Adobe clouds through the capture, aggregation, rationalization and understanding of vast amounts of disparate data and then translating that data into singular customer profiles; includes Adobe Analytics and Adobe Audience Manager.


•	Adobe Advertising Cloud—delivers an end-to-end platform for managing advertising across traditional TV and digital formats, and simplifies the delivery of video, display and search advertising across channels and screens; combines capabilities from Adobe Media Optimizer (“AMO”) and Adobe’s acquisition of TubeMogul during the first quarter of fiscal 2017.

In addition to chief marketing officers and digital marketers, users of our Adobe Experience Cloud solutions include advertisers, campaign managers, digital marketers, publishers, data analysts, content managers, social marketers and marketing executives. These customers often are involved in workflows that utilize other Adobe products, such as our Digital Media offerings. By combining the creativity of our Digital Media business with the science of our Digital Experience business, we help our customers to more efficiently and effectively make, manage, measure and monetize their content across every channel with an end-to-end workflow and feedback loop.

We utilize a direct sales force to market and license our Adobe Experience Cloud solutions, as well as an extensive ecosystem of partners, including marketing agencies, systems integrators and independent software vendors that help license and deploy our solutions to their customers. We have made significant investments to broaden the scale and size of all of these routes to market, and our recent financial results reflect the success of these investments. We achieved record Adobe Experience Cloud revenue of $554.1 million in the first quarter of fiscal 2018, which represents 16% year-over-year growth.

In the first quarter of fiscal 2018, in order to more closely align our Digital Experience segment with the strategic growth opportunity, we moved two legacy enterprise offerings, LiveCycle and Connect, from our Digital Experience segment to our Publishing segment.

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 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 requiring 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.

There have been no significant changes in our critical accounting policies and estimates during the three months ended March 2, 2018, 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 December 1, 2017.

Recent Accounting Pronouncements

See Note 1 of our notes to condensed consolidated financial statements for information regarding recent accounting pronouncements that are of significance or potential significance to us.

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RESULTS OF OPERATIONS

Financial Performance Summary for the First Quarter of Fiscal 2018


•	Total Digital Media ARR of approximately $5.72 billion as of March 2, 2018 increased by $336 million, or 6%, from $5.39 billion as of December 1, 2017. The change in our Digital Media ARR is primarily due to strong adoption of our Creative Cloud and Adobe Document Cloud subscription offerings.


•	Creative revenue during the three months ended March 2, 2018 of $1.23 billion increased by $287.3 million, or 30% compared with the year-ago period. The increase was primarily due to the increase in subscription revenue associated with our Creative Cloud offerings.


•	Adobe Experience Cloud revenue of $554.1 million during the three months ended March 2, 2018 increased by $76.8 million, or 16%, compared with the year-ago period. The increase was primarily due to the increase in subscription revenue across our offerings


•	Our total deferred revenue of $2.57 billion as of March 2, 2018 increased by $77.7 million, or 3%, from $2.49 billion as of December 1, 2017 primarily due to increases in new contracts and the timing of renewals for our Digital Experience hosted service offerings.


•	Cost of revenue of $258.9 million during the three months ended March 2, 2018 increased by $21.6 million, or 9%, compared with the year-ago period primarily due to increases in royalty costs, hosting services and data center costs.


•	Operating expenses of $1.12 billion during the three months ended March 2, 2018 increased by $142.0 million, or 15%, compared with the year-ago period primarily due to increases in costs associated with increased headcount, our incentive compensation program and stock-based compensation expense.


•	Net income of $583.1 million during the three months ended March 2, 2018 increased by $184.6 million, or 46%, compared with the year-ago period primarily due to subscription revenue increases.


•	Net cash flow from operations of $989.6 million during the three months ended March 2, 2018 increased by $259.2 million, or 35%, compared to the three months ended March 3, 2017 primarily due to higher net income.

Revenue for the Three Months Ended March 2, 2018 and March 3, 2017 (dollars in millions)



	Three Months
	2018			2017			% Change
Subscription	$	1,793.3		$	1,383.8		30	%
Percentage of total revenue	86		%	82		%
Product	171.6			183.4			(6	)%
Percentage of total revenue	8		%	11		%
Services and support	114.0			114.4			*
Percentage of total revenue	6		%	7		%
Total revenue	$	2,078.9		$	1,681.6		24	%

^{_________________________________________}


^(*)	Percentage is less than 1%.

Our subscription revenue is comprised primarily of fees we charge for our subscription and hosted service offerings including Creative Cloud and certain of our Adobe Experience Cloud and Document Cloud services. We recognize subscription revenue ratably over the term of agreements with our customers, beginning on the commencement of the service.

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As described in Note 15 of our notes to condensed consolidated financial statements, we have the following reportable segments: Digital Media, Digital Experience and Publishing. Subscription revenue by reportable segment for the three months ended March 2, 2018 and March 3, 2017 is as follows (dollars in millions):



	Three Months
	2018		2017		% Change
Digital Media	$	1,334.6	$	1,006.9	33	%
Digital Experience	430.9		352.9		22	%
Publishing	27.8		24.0		16	%
Total subscription revenue	$	1,793.3	$	1,383.8	30	%

Our services and support revenue is comprised of consulting, training and maintenance and support, primarily related to the licensing of our enterprise products and the sale of our hosted Adobe Experience Cloud services. 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 desktop product upgrades and enhancements or technical support, depending on the offering, are generally recognized ratably over the term of the arrangement.

Segment Information (dollars in millions)



	Three Months
	2018			2017			% Change
Digital Media	$	1,460.5		$	1,138.1		28	%
Percentage of total revenue	70		%	68		%
Digital Experience	554.1			477.3			16	%
Percentage of total revenue	27		%	28		%
Publishing	64.3			66.2			(3	)%
Percentage of total revenue	3		%	4		%
Total revenue	$	2,078.9		$	1,681.6		24	%

Digital Media

Revenue from Digital Media increased $322.4 million during the three months ended March 2, 2018, as compared to the three months ended March 3, 2017 primarily driven by increases in revenue associated with our Creative offerings.