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 August 31, 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 September 21, 2018 was 488,133,527.

ADOBE SYSTEMS INCORPORATED

FORM 10-Q

TABLE OF CONTENTS



		Page No.
PART I—FINANCIAL INFORMATION
Item 1.	Condensed Consolidated Financial Statements:	3
	Condensed Consolidated Balance Sheets August 31, 2018 and December 1, 2017	3
	Condensed Consolidated Statements of Income Three and Nine Months Ended August 31, 2018 and September 1, 2017	4
	Condensed Consolidated Statements of Comprehensive Income Three and Nine Months Ended August 31, 2018 and September 1, 2017	5
	Condensed Consolidated Statements of Cash Flows Nine Months Ended August 31, 2018 and September 1, 2017	6
	Notes to Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	30
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	43
Item 4.	Controls and Procedures	43

PART II—OTHER INFORMATION
Item 1.	Legal Proceedings	43
Item 1A.	Risk Factors	44
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56
Item 4.	Mine Safety Disclosures	56
Item 5.	Other Information	56
Item 6.	Exhibits	57
Signature		62
Summary of Trademarks		63

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)



	August 31, 2018			December 1, 2017
	(Unaudited)			(*)
ASSETS
Current assets:
Cash and cash equivalents	$	1,747,144		$	2,306,072
Short-term investments	3,197,326			3,513,702
Trade receivables, net of allowances for doubtful accounts of $12,034 and $9,151, respectively	1,044,507			1,217,968
Prepaid expenses and other current assets	311,936			210,071
Total current assets	6,300,913			7,247,813
Property and equipment, net	1,019,260			936,976
Goodwill	7,136,853			5,821,561
Purchased and other intangibles, net	669,476			385,658
Deferred income taxes	85,297			—
Other assets	183,821			143,548
Total assets	$	15,395,620		$	14,535,556

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade payables	$	145,566		$	113,538
Accrued expenses	1,020,047			993,773
Income taxes payable	11,222			14,196
Deferred revenue	2,615,192			2,405,950
Total current liabilities	3,792,027			3,527,457
Long-term liabilities:
Debt	1,874,654			1,881,421
Deferred revenue	92,182			88,592
Income taxes payable	622,411			173,088
Deferred income taxes	—			279,941
Other liabilities	152,421			125,188
Total liabilities	6,533,695			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; 489,007 and 491,262 shares outstanding, respectively	61			61
Additional paid-in-capital	5,549,322			5,082,195
Retained earnings	11,137,357			9,573,870
Accumulated other comprehensive income (loss)	(128,048		)	(111,821		)
Treasury stock, at cost (111,827 and 109,572 shares, respectively), net of reissuances	(7,696,767		)	(6,084,436		)
Total stockholders’ equity	8,861,925			8,459,869
Total liabilities and stockholders’ equity	$	15,395,620		$	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.

Table of Contents

ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)



	Three Months Ended						Nine Months Ended
	August 31, 2018			September 1, 2017			August 31, 2018			September 1, 2017
Revenue:
Subscription	$	2,021,505		$	1,570,336		$	5,737,994		$	4,437,882
Product	149,127			158,961			471,728			513,891
Services and support	120,444			111,777			355,661			343,137
Total revenue	2,291,076			1,841,074			6,565,383			5,294,910
Cost of revenue:
Subscription	199,157			168,915			550,197			452,830
Product	11,454			11,709			35,110			41,530
Services and support	84,881			82,298			250,431			245,259
Total cost of revenue	295,492			262,922			835,738			739,619
Gross profit	1,995,584			1,578,152			5,729,645			4,555,291
Operating expenses:
Research and development	398,957			315,555			1,121,854			900,033
Sales and marketing	670,084			550,093			1,897,256			1,623,488
General and administrative	184,063			147,402			532,543			455,139
Amortization of purchased intangibles	23,874			19,428			58,169			57,876
Total operating expenses	1,276,978			1,032,478			3,609,822			3,036,536
Operating income	718,606			545,674			2,119,823			1,518,755
Non-operating income (expense):
Interest and other income (expense), net	1,608			13,539			29,879			25,899
Interest expense	(21,107		)	(18,809		)	(61,369		)	(55,286		)
Investment gains (losses), net	2,251			975			6,326			5,261
Total non-operating income (expense), net	(17,248		)	(4,295		)	(25,164		)	(24,126		)
Income before income taxes	701,358			541,379			2,094,659			1,494,629
Provision for income taxes	35,067			121,810			182,125			302,224
Net income	$	666,291		$	419,569		$	1,912,534		$	1,192,405
Basic net income per share	$	1.36		$	0.85		$	3.89		$	2.41
Shares used to compute basic net income per share	490,025			493,426			491,336			494,138
Diluted net income per share	$	1.34		$	0.84		$	3.84		$	2.38
Shares used to compute diluted net income per share	496,866			500,398			498,587			501,060

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						Nine Months Ended
	August 31, 2018			September 1, 2017			August 31, 2018			September 1, 2017
	Increase/(Decrease)						Increase/(Decrease)
Net income	$	666,291		$	419,569		$	1,912,534		$	1,192,405
Other comprehensive income (loss), net of taxes:
Available-for-sale securities:
Unrealized gains / losses on available-for-sale securities	5,849			3,545			(19,020		)	13,234
Reclassification adjustment for recognized gains / losses on available-for-sale securities	9,645			(488		)	9,842			(894		)
Net increase (decrease) from available-for-sale securities	15,494			3,057			(9,178		)	12,340
Derivatives designated as hedging instruments:
Unrealized gains / losses on derivative instruments	17,524			1,483			47,290			3,613
Reclassification adjustment for recognized gains / losses on derivative instruments	(16,494		)	30			(18,671		)	(31,219		)
Net increase (decrease) from derivatives designated as hedging instruments	1,030			1,513			28,619			(27,606		)
Foreign currency translation adjustments	(15,341		)	43,552			(35,668		)	90,238
Other comprehensive income (loss), net of taxes	1,183			48,122			(16,227		)	74,972
Total comprehensive income, net of taxes	$	667,474		$	467,691		$	1,896,307		$	1,267,377

See accompanying notes to condensed consolidated financial statements.

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ADOBE SYSTEMS INCORPORATED

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



	Nine Months Ended
	August 31, 2018			September 1, 2017
Cash flows from operating activities:
Net income	$	1,912,534		$	1,192,405
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation, amortization and accretion	239,772			244,763
Stock-based compensation	439,941			334,728
Deferred income taxes	(418,114		)	47,859
Unrealized losses (gains) on investments, net	(3,115		)	(3,243		)
Other non-cash items	4,844			2,606
Changes in operating assets and liabilities, net of acquired assets and assumed liabilities:
Trade receivables, net	199,002			26,461
Prepaid expenses and other current assets	(89,823		)	31,824
Trade payables	25,362			(68,397		)
Accrued expenses	4,099			78,297
Income taxes payable	433,559			6,880
Deferred revenue	173,250			185,450
Net cash provided by operating activities	2,921,311			2,079,633
Cash flows from investing activities:
Purchases of short-term investments	(541,878		)	(1,419,411		)
Maturities of short-term investments	606,594			601,130
Proceeds from sales of short-term investments	238,303			978,737
Acquisitions, net of cash acquired	(1,633,041		)	(459,626		)
Purchases of property and equipment	(204,016		)	(140,438		)
Purchases of long-term investments and other assets	(15,288		)	(25,669		)
Proceeds from sale of long-term investments and other assets	2,909			2,034
Net cash used for investing activities	(1,546,417		)	(463,243		)
Cash flows from financing activities:
Purchases of treasury stock	(1,750,000		)	(800,000		)
Proceeds from reissuance of treasury stock	189,743			157,682
Taxes paid related to net share settlement of equity awards	(368,910		)	(220,580		)
Repayment of capital lease obligations	(1,132		)	(1,328		)
Net cash used for financing activities	(1,930,299		)	(864,226		)
Effect of foreign currency exchange rates on cash and cash equivalents	(3,523		)	11,071
Net increase (decrease) in cash and cash equivalents	(558,928		)	763,235
Cash and cash equivalents at beginning of period	2,306,072			1,011,315
Cash and cash equivalents at end of period	$	1,747,144		$	1,774,550
Supplemental disclosures:
Cash paid for income taxes, net of refunds	$	141,674		$	211,343
Cash paid for interest	$	61,754		$	59,769
Non-cash investing activities:
Investment in lease receivable applied to building purchase	$	—		$	80,439
Issuance of common stock and stock awards assumed in business acquisitions	$	2,784		$	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”).

Reclassifications

Certain immaterial prior year amounts have been reclassified to conform to current year presentation in the condensed consolidated statements of cash flows.

Recently Adopted Accounting Guidance

On January 26, 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) 2017-04, 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. The standard did not have an impact to our qualitative assessment for goodwill impairment that we performed in the second quarter of fiscal 2018.

Significant Accounting Policies

There have been no other material changes to our significant accounting policies during the nine months ended August 31, 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 GAAP when it becomes effective and permits the use of either the full retrospective or modified retrospective transition method. 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 believe there should not be a material change to the amount of consolidated revenues on an annual basis.

We expect revenue related to our 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.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

We believe the most significant revenue-related 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 vendor-specific objective evidence (“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 and potentially classify such revenue as “product” instead of “subscription” revenue on the income statement. We offer on-premise term-based software licenses bundled with maintenance and support as a deployment model for certain offerings within our Digital Experience, Digital Media, and Publishing business units. We do not expect these arrangements to have a material impact to revenue reported in annual reporting periods subsequent to adoption, however they may result in a material balance sheet impact on the date of adoption due to the application of the modified retrospective transition method. The modified retrospective method requires upon adoption that we recognize the impact of applying the new standard to contracts that are not completed at the date of initial adoption, but do not restate prior financial statements. We will record a cumulative effect of initially applying the provisions of the new standard as an adjustment to increase the opening retained earnings balance and reduce the opening deferred revenue balance. Further, some of our enterprise agreements allow our customers to renew on-premise term-based licenses on a monthly basis. Revenue associated with these arrangements would be recognized monthly.

Other expected impacts to our policies and disclosures include: earlier recognition of revenue for certain contracts due to the elimination of contingent revenue limitations, an unbilled receivable balance on our balance sheets, the requirement to estimate variable consideration for certain arrangements, increased allocation of revenue to and from professional services and other offerings, and changes to our financial statement disclosures such as remaining performance obligations.

Under current GAAP, we expense costs related 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. There may be a material balance sheet impact at the period of adoption to capitalize costs of obtaining the contract as an asset, with a corresponding adjustment to opening retained earnings at the date of initial adoption. Additionally, we may have to record related deferred income taxes. We continue to evaluate the magnitude of the impact and the period over which these capitalized costs will be amortized.

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 allows for the application of the new guidance at the beginning of the earliest comparative period presented or at the 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.

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.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

With the exception of the new standards discussed above, there have been no other recent accounting pronouncements or changes in accounting pronouncements during the nine months ended August 31, 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

Magento

On June 18, 2018, we completed our acquisition of Magento Commerce (“Magento”), a privately-held commerce platform company. During the third quarter of fiscal 2018, we began integrating Magento into our Digital Experience reportable segment.

The table below represents the preliminary purchase price allocation to the acquired net assets of Magento based on their estimated fair values as of June 18, 2018 and the associated estimated useful lives at that date. The fair values assigned to assets acquired and liabilities assumed are based on management’s best estimates and assumptions as of the reporting date and are considered preliminary pending finalization of valuation analyses pertaining to intangible assets acquired and tax liabilities assumed including the calculation of deferred tax assets and liabilities.



(in thousands)	Amount			Weighted Average Useful Life (years)
Customer contracts and relationships	$	208,000		8
Purchased technology	84,200			5
In-process research and development ⁽¹⁾	39,100			N/A
Trademarks	21,100			3
Other intangibles	43,400			3
Total identifiable intangible assets	395,800
Net liabilities assumed	(67,417		)	N/A
Goodwill⁽²⁾	1,316,217			N/A
Total estimated purchase price	$	1,644,600

^{_________________________________________}


⁽¹⁾	Capitalized as purchased technology and are considered indefinite lived until the completion or abandonment of the associated research and development efforts.


⁽²⁾	Non-deductible for tax-purposes.

TubeMogul

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 as the impact of the acquisitions discussed above was not material to our condensed consolidated financial statements.

Marketo

Subsequent to August 31, 2018, we entered into a definitive agreement to acquire Marketo, Inc. (“Marketo”), a privately-held marketing cloud platform company, for approximately $4.75 billion, subject to customary purchase price adjustments. The transaction is subject to regulatory approvals and customary closing conditions and is expected to close in the fourth quarter of our fiscal 2018. Following the closing, we intend to integrate Marketo into our Digital Experience reportable segment for financial reporting purposes.

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ADOBE SYSTEMS INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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.

Cash, cash equivalents and short-term investments consisted of the following as of August 31, 2018 (in thousands):



	Amortized Cost		Unrealized Gains		Unrealized Losses			Estimated Fair Value
Current assets:
Cash	$	386,927	$	—	$	—		$	386,927
Cash equivalents:
Corporate debt securities	24,012		—		(1		)	24,011
Money market mutual funds	1,302,801		—		—			1,302,801
Time deposits	33,405		—		—			33,405
Total cash equivalents	1,360,218		—		(1		)	1,360,217
Total cash and cash equivalents	1,747,145		—		(1		)	1,747,144
Short-term fixed income securities:
Asset-backed securities	77,393		2		(385		)	77,010
Corporate debt securities	2,471,739		614		(20,590		)	2,451,763
Foreign government securities	4,178		—		(29		)	4,149
Municipal securities	19,223		—		(306		)	18,917
U.S. Treasury securities	645,487		—		—			645,487
Total short-term investments	3,218,020		616		(21,310		)	3,197,326
Total cash, cash equivalents and short-term investments	$	4,965,165	$	616	$	(21,311	)	$	4,944,470

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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 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.

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 August 31, 2018 and December 1, 2017 (in thousands):



	2018					2017
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Corporate debt securities	$	1,218,367	$	(16,414	)	$	1,338,232	$	(5,459	)
Asset-backed securities	28,820		(240		)	64,618		(193		)
Municipal securities	17,975		(281		)	11,805		(115		)
Foreign government securities	4,149		(29		)	2,388		(8		)
U.S. Treasury securities	—		—			593,296		(2,087		)
Total	$	1,269,311	$	(16,964	)	$	2,010,339	$	(7,862	)

There were 767 securities and 894 securities in an unrealized loss position for less than twelve months at August 31, 2018 and at December 1, 2017, respectively.

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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 August 31, 2018 and December 1, 2017 (in thousands):



	2018					2017
	Fair Value		Gross Unrealized Losses			Fair Value		Gross Unrealized Losses
Corporate debt securities	$	312,698	$	(4,176	)	$	500,689	$	(4,666	)
Asset-backed securities	17,560		(145		)	32,383		(210		)
Municipal securities	942		(25		)	598		(17		)
U.S. Treasury securities	—		—			338,950		(1,465		)
Total	$	331,200	$	(4,346	)	$	872,620	$	(6,358	)

There were 197 securities and 360 securities in an unrealized loss position for more than twelve months at August 31, 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 August 31, 2018 (in thousands):



	Amortized Cost		Estimated Fair Value
Due within one year	$	1,643,049	$	1,640,836
Due between one and two years	788,794		782,312
Due between two and three years	608,978		600,690
Due after three years	177,199		173,488
Total	$	3,218,020	$	3,197,326

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 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 nine months ended August 31, 2018 and September 1, 2017, we did not consider any of our investments to be other-than-temporarily impaired.

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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 nine months ended August 31, 2018.

The fair value of our financial assets and liabilities at August 31, 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:
Corporate debt securities	$	24,011	$	—	$	24,011	$	—
Money market mutual funds	1,302,801		1,302,801		—		—
Time deposits	33,405		33,405		—		—
Short-term investments:
Asset-backed securities	77,010		—		77,010		—
Corporate debt securities	2,451,763		—		2,451,763		—
Foreign government securities	4,149		—		4,149		—
Municipal securities	18,917		—		18,917		—
U.S. Treasury securities	645,487		—		645,487		—
Prepaid expenses and other current assets:
Foreign currency derivatives	43,084		—		43,084		—
Other assets:
Deferred compensation plan assets	69,705		3,192		66,513		—
Total assets	$	4,670,332	$	1,339,398	$	3,330,934	$	—



Liabilities:
Accrued expenses:
Foreign currency derivatives	$	2,463	$	—	$	2,463	$	—
Other liabilities:
Interest rate swap derivatives	10,312		—		10,312		—
Total liabilities	$	12,775	$	—	$	12,775	$	—

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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 A+. 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 and nine months ended August 31, 2018 and September 1, 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 $1.91 billion as of August 31, 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 August 31, 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)}	$	41,862	$	—	$	12,918	$	—
Interest rate swap ⁽³⁾	—		10,312		—		1,058
Derivatives not designated as hedging instruments:
Foreign exchange forward contracts ⁽¹⁾	1,222		2,463		1,280		1,598
Total derivatives	$	43,084	$	12,775	$	14,198	$	2,656

^{_________________________________________}


⁽¹⁾	Fair value asset derivatives included in prepaid expenses and other current assets and fair value liability derivatives included in accrued expenses on our 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 and nine months ended August 31, 2018 was as follows (in thousands):



	Three Months						Nine Months
	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⁾	$	17,523		$	—		$	47,290		$	—
Net gain (loss) reclassified from accumulated OCI into income, net of tax⁽²⁾	$	16,797		$	—		$	18,156		$	—
Net gain (loss) recognized in income⁽³⁾	$	(9,281	)	$	—		$	(31,690	)	$	—
Derivatives not designated as hedging relationships:
Net gain (loss) recognized in income⁽⁴⁾	$	—		$	(1,695	)	$	—		$	(2,572	)



	Three Months					Nine Months
	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⁾	$	1,483		$	—	$	3,613		$	—
Net gain (loss) reclassified from accumulated OCI into income, net of tax⁽²⁾	$	221		$	—	$	31,845		$	—
Net gain (loss) recognized in income⁽³⁾	$	(6,190	)	$	—	$	(21,842	)	$	—
Derivatives not designated as hedging relationships:
Net gain (loss) recognized in income⁽⁴⁾	$	—		$	2,920	$	—		$	6,456

^{_________________________________________}


⁽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.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 6. GOODWILL AND PURCHASED AND OTHER INTANGIBLES

Goodwill as of August 31, 2018 and December 1, 2017 was $7.14 billion and $5.82 billion, respectively. The increase was primarily due to our acquisition of Magento in the third quarter of fiscal 2018.

Purchased and other intangible assets subject to amortization as of August 31, 2018 and December 1, 2017 were as follows (in thousands):



	2018							2017
	Cost		Accumulated Amortization			Net		Cost		Accumulated Amortization			Net
Purchased technology	$	307,101	$	(100,832	)	$	206,269	$	223,252	$	(110,433	)	$	112,819
Customer contracts and relationships	$	753,870	$	(387,091	)	$	366,779	$	577,484	$	(356,613	)	$	220,871
Trademarks	56,355		(20,016		)	36,339		76,255		(56,094		)	20,161
Acquired rights to use technology	58,966		(47,097		)	11,869		71,130		(54,223		)	16,907
Other intangibles	81,357		(33,137		)	48,220		39,296		(24,396		)	14,900
Total other intangible assets	$	950,548	$	(487,341	)	$	463,207	$	764,165	$	(491,326	)	$	272,839
Purchased and other intangible assets, net	$	1,257,649	$	(588,173	)	$	669,476	$	987,417	$	(601,759	)	$	385,658

Amortization expense related to purchased and other intangible assets was $47.0 million and $115.5 million for the three and nine months ended August 31, 2018, respectively. Comparatively, amortization expense related to purchased and other intangible assets was $39.1 million and $116.3 million for the three and nine months ended September 1, 2017, respectively. Of these amounts, $23.1 million and $57.1 million were included in cost of sales for the three and nine months ended August 31, 2018, respectively, and $19.5 million and $57.7 million the three and nine months ended September 1, 2017, respectively.

During the nine months ended August 31, 2018, purchased and other intangible assets, net increased primarily due to identifiable intangible assets acquired through Magento, offset in part by write-offs of fully amortized purchased intangibles associated with our acquisitions of Omniture, Inc. and Day Software Holding AG from the condensed consolidated balance sheets. See Note 2 for details regarding our acquisitions.

As of August 31, 2018, we expect amortization expense in future periods to be as follows (in thousands):



Fiscal Year	Purchased Technology		Other Intangible Assets
Remainder of 2018	$	13,596	$	36,274
2019	51,112		118,652
2020	48,820		86,498
2021	26,369		54,119
2022	18,610		39,749
Thereafter	47,762		127,915
Total expected amortization expense	$	206,269	$	463,207

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

NOTE 7. ACCRUED EXPENSES

Accrued expenses as of August 31, 2018 and December 1, 2017 consisted of the following (in thousands):



	2018		2017
Accrued compensation and benefits	$	428,575	$	417,742
Accrued media costs	103,470		134,525
Sales and marketing allowances	46,432		47,389
Accrued corporate marketing	76,574		72,087
Taxes payable	50,149		49,550
Royalties payable	42,742		46,411
Accrued interest expense	10,469		25,594
Other	261,636		200,475
Accrued expenses	$	1,020,047	$	993,773

Accrued media costs primarily relate to our advertising platform offerings 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 reduced 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 required 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 was effective in the first quarter of our fiscal 2018. As of August 31, 2018, we have not completed our accounting for the tax effects of the Tax Act. During the quarter, we recorded an adjustment to the 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 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 the subsequent reporting period when our accounting analysis is finalized, as permitted by SEC Staff Accounting Bulletin 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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 and recorded 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 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 was 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. As a result of a change to our corporate tax structure that provided us the ability to deduct more expenses against our earnings in the U.S., we updated our Tax Act calculation during the three months ended June 1, 2018. This included an additional provisional transition tax expense of $28 million on deferred foreign earnings, a decrease of deferred tax assets by $72 million which also included utilization of credits that we estimate will be available to reduce the transition tax, and a reduction of long-term income tax payable by $44 million. As a result of technical guidance updates on the interpretations of the Tax Act available in the quarter, we updated our Tax Act calculation during the three months ended August 31, 2018. The application of this guidance resulted in an additional net provisional tax expense of $24 million, a decrease of net deferred tax assets by $25 million, an increase in unrecognized tax benefits included in the long-term income tax payable of $69 million, a reduction of the short-term income taxes payable of $7 million, and a reduction to the long-term income tax payable of $62 million. To calculate the transition tax, we estimated our deferred foreign income for fiscal 2018 because the information needed to complete the calculation will not be known until our taxable income is known. 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 intend to elect to pay the federal transition tax over a period of eight years as permitted by the Tax Act. As a result, in the second quarter of fiscal 2018, we reclassified $39 million from long-term income taxes payable to short-term income taxes payable for the first installment payment due in fiscal 2019. During the three months ended August 31, 2018, we reclassified $5 million from short-term income taxes payable to long-term income taxes payable as a result of the updated technical guidance on the interpretations of 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 nine months ended August 31, 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 nine months ended August 31, 2018 and the fiscal year ended December 1, 2017 was as follows (in thousands):



	2018		2017
Beginning outstanding balance	9,304		8,316
Awarded	3,742		5,018
Released	(3,686	)	(3,859	)
Forfeited	(525	)	(766	)
Increase due to acquisition	—		595
Ending outstanding balance	8,835		9,304

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Information regarding restricted stock units outstanding at August 31, 2018 and September 1, 2017 is summarized below:



	Number of Shares (thousands)	Weighted Average Remaining Contractual Life (years)	Aggregate Intrinsic Value^(*) (millions)
2018
Restricted stock units outstanding	8,835	1.23	$	2,328.1
Restricted stock units vested and expected to vest	8,104	1.18	$	2,135.7
2017
Restricted stock units outstanding	9,443	1.27	$	1,464.2
Restricted stock units vested and expected to vest	8,636	1.22	$	1,339.1

^{_________________________________________}


^(*)	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 August 31, 2018 and September 1, 2017 were $263.51 and $155.06, 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 August 31, 2018, the shares awarded under our 2018, 2017 and 2016 Performance Share Programs are yet to be achieved.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table sets forth the summary of performance share activity under our Performance Share Programs for the nine months ended August 31, 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	)		(1,053	)	(1,135	)		(1,147	)
Forfeited	(165	)		(331	)	(43	)		(86	)
Ending outstanding balance	1,156			2,312		1,534			3,068

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⁽¹⁾	Included in the 0.8 million shares awarded during the nine months ended August 31, 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 and nine months ended August 31, 2018 and September 1, 2017 were as follows:



	Three Months			Nine Months
	2018		2017	2018	2017
Expected life (in years)	0.5 - 2.0		0.5 - 2.0	0.5 - 2.0	0.5 - 2.0
Volatility	29	%	25% - 27%	26% - 29%	22% - 27%
Risk free interest rate	2.09% - 2.52%		1.12% - 1.41%	1.54% - 2.52%	0.62% - 1.41%

Employees purchased 1.8 million shares at an average price of $104.94 and 1.9 million shares at an average price of $77.63 for the nine months ended August 31, 2018 and September 1, 2017, respectively. The intrinsic value of shares purchased during the nine months ended August 31, 2018 and September 1, 2017 was $198.9 million and $97.7 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. However, we may assume the stock option plans of certain companies we acquire. As of August 31, 2018 and December 1, 2017, we had 0.3 million stock options outstanding at each period end.

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Compensation Costs

As of August 31, 2018, there was $1.09 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 1.9 years. Total unrecognized compensation cost will be adjusted for future changes in estimated forfeitures.

Total stock-based compensation costs included in our condensed consolidated statements of income for the three months ended August 31, 2018 and September 1, 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	$	934	$	4,509	$	628	$	3,633
Cost of revenue—services and support	1,930		2,789		1,626		2,409
Research and development	6,347		66,308		4,608		43,243
Sales and marketing	7,551		47,885		4,658		36,064
General and administrative	2,932		17,853		1,140		19,033
Total	$	19,694	$	139,344	$	12,660	$	104,382

Total stock-based compensation costs included in our condensed consolidated statements of income for the nine months ended August 31, 2018 and September 1, 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	$	2,431	$	12,979	$	1,899	$	10,467
Cost of revenue—services and support	5,593		8,455		4,850		7,151
Research and development	16,997		183,989		12,884		119,068
Sales and marketing	18,314		129,480		13,832		103,982
General and administrative	5,762		55,941		3,623		56,972
Total	$	49,097	$	390,844	$	37,088	$	297,640

NOTE 10. STOCKHOLDERS’ EQUITY

Retained Earnings

The changes in retained earnings for the nine months ended August 31, 2018 were as follows (in thousands):



Balance as of December 1, 2017	$	9,573,870
Net income	1,912,534
Reissuance of treasury stock	(348,729		)
Adjustments to equity as a result of the Tax Act	(318		)
Balance as of August 31, 2018	$	11,137,357

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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.

The components of accumulated other comprehensive income (loss) and activity, net of related taxes, as of August 31, 2018 were as follows (in thousands):



	December 1, 2017			Increase / Decrease			Reclassification Adjustments				August 31, 2018
Net unrealized gains / losses on available-for-sale securities:
Unrealized gains on available-for-sale securities	$	2,704		$	(1,836	)	$	(252	)		$	616
Unrealized losses on available-for-sale securities	(14,220		)	(17,184		)	10,094				(21,310		)
Total net unrealized gains / losses on available-for-sale securities	(11,516		)	(19,020		)	9,842			⁽¹⁾	(20,694		)
Net unrealized gains / losses on derivative instruments designated as hedging instruments	(3,367		)	47,290			(18,671		)	⁽²⁾	25,252
Cumulative foreign currency translation adjustments	(96,938		)	(35,668		)	—				(132,606		)
Total accumulated other comprehensive income (loss), net of taxes	$	(111,821	)	$	(7,398	)	$	(8,829	)		$	(128,048	)

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⁽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 and nine months ended August 31, 2018 and September 1, 2017 (in thousands):



	Three Months						Nine Months
	2018			2017			2018			2017
Available-for-sale securities:
Unrealized gains / losses	$	—		$	235		$	—		$	523
Reclassification adjustments	—			(214		)	—			(323		)
Subtotal available-for-sale securities	—			21			—			200
Derivatives designated as hedging instruments:
Reclassification adjustments on derivative instruments	(101		)	(149		)	(1,726		)	(582		)
Foreign currency translation adjustments	—			1,434			(1,742		)	3,081
Total taxes, other comprehensive income	$	(101	)	$	1,306		$	(3,468	)	$	2,699

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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 our current stock repurchase program granting us authority to repurchase up to $2.5 billion in common stock through the end of fiscal 2019. In May 2018, our Board of Directors granted us another authority to repurchase up to $8 billion in common stock through the end of fiscal 2021.

During the nine months ended August 31, 2018 and September 1, 2017, we entered into several structured stock repurchase agreements with large financial institutions, whereupon we provided them with prepayments totaling $1.75 billion and $800 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 nine months ended August 31, 2018, we repurchased approximately 7.1 million shares at an average price of $225.15 through structured repurchase agreements entered into during fiscal 2017 and the nine months ended August 31, 2018. During the nine months ended September 1, 2017 we repurchased approximately 6.3 million shares at an average price of $126.58 through structured repurchase agreements entered into during fiscal 2016 and the nine months ended September 1, 2017.

For the nine months ended August 31, 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 August 31, 2018 were excluded from the computation of earnings per share. As of August 31, 2018, $247.3 million of prepayment remained under this agreement.

As of August 31, 2018, $150 million remains under the $2.5 billion authority and we have not drawn from our $8 billion 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 and nine months ended August 31, 2018 and September 1, 2017 (in thousands, except per share data):



	Three Months				Nine Months
	2018		2017		2018		2017
Net income	$	666,291	$	419,569	$	1,912,534	$	1,192,405
Shares used to compute basic net income per share	490,025		493,426		491,336		494,138
Dilutive potential common shares:
Unvested restricted stock units and performance share awards	6,716		6,664		7,109		6,574
Stock options	125		308		142		348
Shares used to compute diluted net income per share	496,866		500,398		498,587		501,060
Basic net income per share	$	1.36	$	0.85	$	3.89	$	2.41
Diluted net income per share	$	1.34	$	0.84	$	3.84	$	2.38

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(Unaudited)

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 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.

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(Unaudited)

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.

As of August 31, 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 $1.91 billion as of August 31, 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 August 31, 2018, we were in compliance with all of the covenants.

In February and August 2018, we made semi-annual interest payments on our 2020 and 2025 Notes each 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