Adobe Q2 Digest and Conference Call

Adobe (Nasdaq: ADBE) reported second-quarter earnings this week and hosted an investor call. Here's a Foolish digest for current or prospective Adobe investors.

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Further Adobe news and analysis:

• Analysis: Adobe Doth Protest Too Much (Fool.com)
• Adobe Q2 Earnings Press Release (Adobe.com)
• Adobe Q2 Investor Data Sheet (Adobe.com)
• Adobe Posts Higher Q2 Profit As Revenue Soars (Associated Press)

What follows is a lightly edited transcript of the conference call.

Mike Saviage, vice president of investor relations, Adobe

Good afternoon and thank you for joining us today. Joining me on the call are Adobe's President and CEO, Shantanu Narayen, as well as Mark Garrett, Executive Vice President and CFO. In the call today, we will discuss Adobe's second quarter fiscal year 2010 financial results. By now, you should have a copy of our earnings press release which crossed the wire approximately one hour ago. If you need a copy of the press release, you can go to Adobe.com under the Company and Press links to find an electronic copy.

Before we get started, I want to emphasize that some of the information discussed in this call, particularly our revenue and operating model targets, and our forward-looking product plans, is based on information as of today, June 22, 2010, and contains forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the Forward-Looking Statements Disclosure in the earnings press release we issued today, as well as Adobe's SEC filings. During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in today's earnings release and on our investor relations website in the investor data sheet. Call participants are advised that the audio of this conference call is being broadcast live over the Internet in Adobe Connect, and is also being recorded for playback purposes. An archive of the call will be made available on Adobe's investor relations website for approximately 45 days, and is the property of Adobe Systems. The audio and archive may not be re-recorded, or otherwise reproduced or distributed without prior written permission from Adobe Systems.

I will now like to turn the call over to Shantanu.

Shantanu Narayen, president and chief executive officer, Adobe

Thanks, Mike, and good afternoon. In Q2 we achieved record revenue of $943 million, with non-GAAP earnings per share of $0.44. In addition to a successful CS5 launch, we had solid results across all of our businesses and geographies. We continue to execute well against our strategic goals, providing great value to our customers, which is resulting in strong performance. I'll spend a few minutes discussing Q2 business highlights. Then Mark will provide additional details about the quarter and our financial targets. Following that, I will close with a discussion on our longer-term objectives and we'll take your questions.

In our Creative Solutions business, positive product reviews, industry buzz and pent-up customer demand drove strong Creative Suite 5 adoption in all major geographic regions in the quarter. Our team has delivered an amazing set of products with new innovative features, performance improvements, and work flow enhancements to help customers deliver rich and engaging content across media types, platforms and devices. Our strategy to drive more Suites adoption and revenue is succeeding. 71% of the CS5 product family revenue we achieved in Q2 was Suites-based, an all-time high. We are also seeing success with our video editing tools, which helped drive strong growth for our video solutions, including Master Collection. While early in the cycle, CS5 sales were particularly strong on the Mac.

In Q2, we also made progress against two long-term strategic goals. We achieved record Creative Suite orders on Adobe.com, and record revenue in the education market. Based on initial results and feedback from customers, we believe the adoption of CS5 will remain strong through the end of this year and into next year as large customers evaluate and transition to the new release.

Our Omniture business had another solid quarter in Q2, with strong bookings and the addition of more than a hundred net new customers. Awareness of the strategic value Adobe can provide across an entire workflow involving creation, delivery and optimization is resonating with our big enterprise customers. In fact, we booked a significant multi-year enterprise win for more than $6 million that spanned all major Adobe products from creative tools to LiveCycle and Omniture solutions.

In our Acrobat business, the strength we experienced in Q4 and Q1 continued through Q2. Enterprise licensing was particularly strong, demonstrating the Acrobat and PDF value proposition continues to resonate with large customers. We are on track to deliver a new version of Acrobat late in Q4 that will focus on enabling knowledge workers and enterprises to collaborate across critical document workflows.

In our Enterprise segment, both Connect and LiveCycle had a strong bookings quarter and continue to gain traction in key vertical markets such as government and financial services. Enabling our customers to deliver engaging experiences across multiple devices remains a focus of the company. Today we announced availability of Flash Player 10.1 for mobile devices, which delivers on the promise of enabling access to the full web across desktops and devices. We expect millions of devices to ship with 10.1 in the second half of 2010.

Flash is strategic for Adobe because it delivers great value to our customers. Approximately 3.5 million Flash designers and developers are working with Flash-based solutions today, and their ranks grew by 59% in 2009. The new release of Flash Player creates a whole new sandbox for these millions of designers and developers to create next-generation content, advertising, games, applications and experiences. We've already seen that those who have been using the new Flash Player on Android phones love it, and as devices start to ship with Flash during the rest of the year, those that don't have Flash on their smartphones will wish they did.

Now I'll turn the call over to Mark for some commentary on our financial results, then I will close with some remarks on our long-term strategic outlook.

Mark Garrett, executive vice president and chief financial officer, Adobe

Thanks Shantanu. For the second quarter of fiscal 2010, Adobe achieved record revenue of $943 million. This compares to $704.7 million reported in Q2 fiscal 2009, and $858.7 million reported last quarter. Our Q2 revenue includes $83.5 million in Omniture revenue, but excludes $8.7 million in deferred Omniture revenue in accordance with business combination accounting guidelines. As a reminder, Q1 fiscal 2010 included an extra week of revenue due to our 52/53 week financial calendar and should be factored when making sequential quarter comparisons. We entered the second quarter with approximately 6% of reported Q1 revenue in shippable backlog, and we exited the second quarter with approximately 7% of reported Q2 revenue in shippable backlog.

Q2 GAAP operating expenses were $607.9 million, compared to $471.3 million reported in Q2 fiscal 2009, and $592.5 million last quarter. Non-GAAP operating expenses in Q2 were $520.2 million, compared to $410.6 million reported for Q2 fiscal 2009, and $498.7 million last quarter. Given the strength of our business in the first half of 2010, we decided to invest more in sales and marketing during the quarter.

GAAP operating income in Q2 fiscal 2010 was $227.3 million, or 24.1% of revenue. This compares to GAAP operating income of $161.4 million, or 22.9% of revenue in Q2 fiscal 2009, and $176.8 million, or 20.6% of revenue last quarter.

Non-GAAP operating income in Q2 fiscal 2010 was $334.5 million, or 35.5% of revenue. This compares to non-GAAP operating income of $237.7 million, or 33.7% of revenue in Q2 fiscal 2009, and $289.3 million, or 33.7% of revenue last quarter.

Adobe's effective GAAP tax rate in Q2 was 23.5%, and the non-GAAP tax rate was 25%. Our non-GAAP tax rate remains higher this quarter due to the expiration of the R&D tax credit.

Q2 GAAP net income was $148.6 million compared to $126.1 million reported in Q2 fiscal 2009, and $127.2 million last quarter. Non-GAAP net income in Q2 was $234.2 million, compared to $185 million reported in Q2 fiscal 2009, and $211.7 million last quarter. GAAP diluted earnings per share for Q2 fiscal 2010 were $0.28 based on 533.3 million weighted average shares. This compares with GAAP diluted earnings per share of $0.24 reported in Q2 fiscal 2009, based on 528 million weighted average shares, and GAAP diluted earnings per share of $0.24 reported last quarter, based on 532.6 million weighted average shares. Non-GAAP diluted earnings per share for Q2 fiscal 2010 were $0.44. This compares with non-GAAP diluted earnings per share of $0.35 in Q2 fiscal 2009, and $0.40 reported last quarter.

I will now discuss Adobe's results in Q2 by business segment. Creative Solutions segment revenue was $532.7 million, compared to $411.7 million in Q2 fiscal 2009, and $432 million last quarter. This 29% year-over-year growth was driven by strong performance in our CS business in all major geographies, both with CS4 in the first two months of the quarter, and then with the newly released CS5 in the last five weeks of the quarter. With a strong finish, CS4 finished by lagging the revenue achieved with CS3 by 17%. While it's still early days with our new release, we can make these comments about the first five weeks of CS5 results. Comparing similar periods of availability for CS5 and CS4 products, CS5 revenue is exceeding what we achieved with CS4 by approximately 15%. Regarding ranking of Suites by revenue, results are consistent with the CS4 cycle. Design Premium, Design Standard and Master Collection remain the best selling suites. And CS5 products containing Flash authoring and output as a product component achieved revenue growth of 22% version-over-version to date.

To better reflect the charter of our enterprise business, we renamed our Business Productivity business unit to Digital Enterprise Solutions, and it continues to include our Knowledge Worker and Enterprise reporting segments. Digital Enterprise Solutions' Q2 revenue was $232.7 million, compared to $209.7 million in Q2 fiscal 2009, and $245.8 million last quarter. Within Digital Enterprise Solutions, Knowledge Worker revenue was $156 million, compared to $137.8 million in Q2 fiscal 2009, and $165.9 million last quarter.

Acrobat revenue grew 13% year-over-year, and the weekly run-rates of licensing and shrink-wrap revenue remained consistent with the solid results we achieved in Q1.

Enterprise revenue was $76.7 million, compared to $71.9 million in Q2 fiscal 2009, and $79.9 million last quarter. We achieved 12% year-over-year growth with LiveCycle, and we had a strong bookings quarter for both LiveCycle and Connect. With a solid pipeline in both businesses, we continue to expect this segment to grow sequentially on a go-forward basis.

In our Omniture segment, we achieved $83.5 million in reported revenue, which is down sequentially when compared to Q1 as expected due to Q1 having an extra week in the quarter. Excluding the accounting write-down of $8.7 million in deferred revenue in Q2, reported revenue would have been $92.2 million. Omniture transactions grew to 1.26 trillion in Q2, up from 1.23 trillion in Q1, and up by more than 12% on a year-over-year basis for the equivalent period of time last year. Revenue from our optimization products grew to 43% of Omniture revenue, demonstrating the value proposition of the entire Online Marketing Suite is resonating with customers.

Platform revenue in Q2 was $45.4 million, compared to $36.8 million in Q2 fiscal 2009, and $46.6 million last quarter.

Finally, Print and Publishing segment revenue was $48.7 million, compared to $46.5 million in Q2 fiscal 2009, and $46.6 million last quarter.

Turning to our geographic segments, results on a percent of revenue basis were as follows: The Americas 48%, Europe 29%, Asia 23%. We continue to experience stability in our business in all our major geographies, and have not seen any impact to our business in Europe as a result of the debt crisis.

Employees at the end of Q2 totaled 8,541, versus 8,355 at the end of the last quarter.

Our trade DSO was 42 days, which compares to 34 days in the year-ago quarter, and 40 days last quarter. The slight increase was due to the timing of the CS5 launch, as well as an increase in deferred revenue.

Our global channel inventory position at the end of the quarter was within company policy. During the quarter, cash flow from operations was $251 million. A non-recurring item related to taxes for the Omniture acquisition reduced operating cash flow by approximately $119 million. Our ending cash and short-term investment position was $2.6 billion, compared to $2.7 billion at the end of Q1. In Q2, we repurchased approximately 2.5 million shares at a total cost of $84.7 million.

We also announced today our Board has approved an amendment to our existing stock repurchase program that modifies it from a share-based authority program to offset dilution to a dollar-based authority. As part of this amendment, Adobe can repurchase up to $1.6 billion in common stock through the end of fiscal 2012. The repurchases will be funded from available working capital.

This concludes my discussion of our financial results. I would now like to comment on our financial targets for the third quarter of fiscal 2010. We are targeting a Q3 revenue range of $950 million to $1 billion dollars. This target range excludes an estimated $5 million in deferred Omniture revenue in accordance with business combination accounting guidelines. Assuming achievement of the midpoint of our targeted revenue range, our Q3 revenue expectations by business segment are as follows: we expect our Creative business to grow slightly in Q3 when compared to revenue achieved in Q2; we expect our enterprise and our Omniture businesses to grow sequentially; and we expect Knowledge Worker, Platform and Print & Publishing businesses to be essentially flat with the revenue achieved in Q2.

For margins, we are targeting a Q3 GAAP operating margin range of 25.5% to 27.5%, and a non-GAAP operating margin range of 36% to 37%. We are targeting our Q3 share count to be 532 million to 534 million shares. We are targeting non-operating expense to be between $12.5 million and $13.5 million on both a GAAP and non-GAAP basis. For our Q3 GAAP and non-GAAP effective tax rates we are targeting approximately 25%. These targets lead to a GAAP earnings per share range of $0.32 to $0.37 per share, and a non-GAAP earnings per share range of $0.46 to $0.50.

In Q4, we expect margins to be approximately the same as those targeted in Q3. We also expect Q4 revenue to grow sequentially from Q3.

This concludes my section. I'd now like to turn the call back over to Shantanu.

Shantanu Narayen

Thanks, Mark. Adobe is one of the most diversified software companies in the world. Market trends and dynamics in the industry are positively affecting all of our major businesses, and creating significant opportunities. These opportunities relate to the ongoing explosion of digital content, and the challenges our customers face in creating, delivering and optimizing that content. Every customer I meet expresses a desire to get more value from their content. They want to engage with their constituents more easily and more quickly in a cost-effective manner. They want to migrate their businesses online. They want to extend their brand using the newest means available to them, such as behavioral targeting. They want to replace inefficient paper-based workflows with digital document workflows. They want to enable rich, engaging experiences on the Web, and provide access to their information to reach across every screen in a consumer's life. This is a massive opportunity.

Innovation and our execution against opportunities like this have driven our growth for more than 25 years. We enable our customers to create engaging experiences, deliver them across multiple devices, and optimize and monetize their brand and assets. Our approach has always been to enable these capabilities in ways that are operating system, platform and format agnostic. We have created widely-used standards such as Postscript, Flash and PDF and support other industry standards such as JPEG, HTML and H.264.

Given this strategic market position, given our strong brand and the use of our products by tens of millions of customers, given the ubiquitous reach of our solutions across hundreds of millions of PCs and devices, and given the track record of consistent execution against our strategy and financial targets, we believe Adobe is significantly undervalued today. We are going to take advantage of what we believe is an undervalued stock price, and as Mark mentioned earlier, we will aggressively buy back our stock utilizing excess cash and the strong cash flow that our business generates. By fiscal 2012, our goal is to achieve $5 billion in revenue. We plan to drive double-digit growth in our existing businesses and supplement that with strategic small- and medium-sized M&A. We have demonstrated with our successful acquisitions of Macromedia, Scene7 and Omniture that we can expand our market opportunity and drive incremental growth while enhancing our strategic relationship with a broad set of customers.

Given our focus on expanding our value proposition and driving top line growth, we expect to deliver operating margins consistent with what we plan to achieve in fiscal 2010. We anticipate delivering earnings growth at a rate that meets or exceeds our top line growth rate, and we expect to maintain the delivery of strong operating cash flow.

Adobe has always been at the heart of making engaging experiences happen. We fuel the content creation and delivery ecosystem in a way no other technology company can, which will drive revenue and earnings growth in the years to come.

Thank you for joining us today. Now, I'll turn the call back over to Mike.

Mike Saviage

Thanks, Shantanu. Before we begin Q&A, I'd like to cover a few housekeeping items.

We have announced the dates for Adobe MAX, which will be held again this year in Los Angeles. Every year, MAX brings together thousands of Adobe users, developers and partners, and is a great time to see Adobe in action. This year, MAX will occur during the week of October 25, and like last year, we will host a financial analyst meeting on Wednesday during MAX. Please save the date and mark your calendars to attend MAX, as well as our analyst meeting on Wednesday October 27. The analyst meeting will be condensed to a half day this year, starting in the morning and ending with a lunch with Adobe management. You can learn more about MAX at the MAX website, max.adobe.com. Formal invitations for our analyst day will be sent out this summer.

For many years we've offered a service whereby investors and analysts can sign up on Adobe.com to receive Adobe press releases via email when they cross the wire. During the remainder of fiscal 2010, we will begin to phase out this email service. In its place we are offering today several RSS feeds that you can subscribe to on Adobe.com. Our investor relations web page provides RSS feed information to subscribe to Adobe press releases, as well as the Quick Links investor relations page for new investor- related documents. By subscribing to these RSS feeds, your RSS reader will be notified when new documents are posted to these locations by Adobe and give you easy access to them. We've also added a new link on the IR page of Adobe.com which points to Adobe's corporate blog feed. Adobe utilizes these web delivery capabilities as a means to communicate material information to the financial community. For reference, we've posted these URLs in the Connect archive of today's call.

In regard to today's earnings report, we have posted several documents on our Investor Relations Web page today, including a copy of the script containing our prepared remarks for today's call. To access these documents and the other investor-related information I've highlighted, you can go to our web site at www.adobe.com/adbe.

For those who wish to listen to a playback of today's conference call, a web-based Adobe Connect archive of the call will be available from the IR page on Adobe.com later today. Alternatively, you can listen to a phone replay by calling 888-203-1112. Use conference ID #5434821. Again, the phone number is 888-203-1112 with ID #5434821. International callers should dial 719-457-0820. The phone playback service will be available beginning at 4:00 p.m. Pacific Time today, and ending at 4:00 p.m. Pacific Time on Friday June 25, 2010.

We would now be happy to take your questions. In addition to questions that come in from those participating on the live phone call, we have also enabled the Question pod in the Connect session. So those on the Connect session, feel free to send in your questions and we'll try to take a few in addition to those that come in via the phone line. Operator, we'll take the first question from the phones.

Brent Thill, UBS

Q - Thanks. Shantanu, on Europe, you're up 1%. Sequentially, the U.S. and Asia outpaced the growth. Can you just give us a sense of what you're seeing in Europe, and does the CS5 lag have an impact in what you're eventually going to see in the third and fourth quarter in terms of the growth?

Shantanu Narayen

A - So, Brent, in terms of what we are seeing by geographies, we had a strong quarter virtually across every geography, and we really haven't - and I think Mark alluded to this also in the prepared remarked - seen any impact so far in Europe. I mean, you do have the traditional Q3 seasonalities in Europe, but with respect to CS5, the launch has been strong across all geographies, across all market segments.

Mark Garrett

A - And Brent, this is Mark. I'll add to that since this question's going to come up anyway. We did have a quarter-over-quarter loss to revenue of approximately $22 million from currency. So that, obviously, impacted our Europe results. Year-over-year was actually a gain of 13, but quarter-over-quarter was a loss of 22. We do hedge, and we do get some benefit from hedging from time to time. It wasn't actually a significant benefit this quarter. It was about $6 million that is not included in those numbers I just gave you. But when you look at the rest of this year, based on the hedges that we do have in place already, we expect to have about $30 million worth of hedging benefit in Q3 and Q4 of this year as a result of our program. It's spread out between Q3 and Q4.

Brent Thill

Q - OK, Mark, just a quick follow-up in CAPEX. It doubled from last quarter and it's up about 5 X from last year's. Is that a trend we should continue to see as you move more towards the cloud?

Mark Garrett

A - No, not at all actually. There's a couple things in CAPEX and a couple things that related to cash this quarter that are worth highlighting. So in CAPEX, we had some land purchases. The three headquarter buildings here in San Jose, two of them we just closed the land underneath those buildings, so we now own the land underneath those buildings. We also bought some land in India for expansion. So the two of those together were about $20 million. The India land shows up as a separate line because it's leased land, a 99-year lease. But the San Jose towers are in that CAPEX line. The other thing in CAPEX was a significant investment in our data centers, which is more of a one-time investment of about $25 million. So a couple of unique one-time items that have impacted capital as well as cash.

Brent Thill

Thank you.

Adam Holt, Morgan Stanley

Q - Hi, thank you, and congrats on the good start to the CS cycle. I guess I had two questions about the early data that you have. First of all, can you talk a little bit about what the mix was between units and average selling prices in driving up the cycle-on-cycle growth? And secondly, you know, as you look at the 15% versus CS4, would you expect that to accelerate as you get deeper into the cycle, or how should we be thinking about that?

Shantanu Narayen

A - Yeah, Adam, I'll take those. And again, clearly CS5 was off to a very, very solid start. And we are shipping all major languages, and we've seen strength across geographies. In terms of the revenue itself in the quarter, units certainly drove a majority of the sequential and year-over-year increase in the revenue, and so we're seeing units. ASP has also gone up, as you know, we added Flash catalyst to a number of the Suites, so we're certainly seeing the impact of that. Tiered pricing is also starting to kick in right now as we get version skippers to move from CS3 and earlier versions to CS5. In terms of what we should expect within the cycle - your second question - we said it's 15% greater than CS4. We would expect that to actually increase over the cycle. And I know one question that's probably come up sometime today is, how does this compare with CS3? It's been actually very strong, and we expect it to be closer to CS3.

Adam Holt

Q - If I could just ask one follow-up. At the end of your comments you gave us some sort of longer-term guidance. It looks like you're implying about 15% annualized revenue growth, margins that are a little bit more flattish and maybe the buy-back helping to accelerate earnings to maybe, you know, better than 15% growth over the next two years. Is that generally the right way to take the comments that you made at the end of the call about the medium term?

Mark Garrett

A - Yeah, Adam, this is Mark. That's exactly right. It represents, depending on what you believe the rest of this year will be, somewhere in that 15% annual growth for revenue. We believe earnings should grow at least as fast as revenue. We're going to be more focused on driving earnings and strong cash flow. Cash flow this quarter was uniquely impacted due to some one-time things. But as you know, this is a very strong cash flow business model and we're really going to focus on driving revenue growth, earnings growth, and cash flow.

Heather Bellini, ISI Group

Q - Yeah, hi. I had a question. Shantanu, you mentioned that you expected this cycle to be closer to CS3. I was just wondering, if you go through it, given the number of people that didn't upgrade the CS4 and the pricing changes that you made, that people that skipped releases, is there a reason why we couldn't see it be better than CS3? And then my follow-up to that, I guess for Mark, would be the headcount that you added this quarter, I think roughly 190 people or so. Should we expect that same growth in heads to continue? Thanks, guys.

Shantanu Narayen

A - So Heather, when we looked at the business and the early results for CS5, again, we were pleased. I think it's fair to say it's early in the quarter. When we look at the mix of Suites versus the point products, that looked good. The demand for the Flash set of products was high. Education, which is a long-term strategic investment for the company - Education was very strong in the quarter, which is not your traditionally strong quarter. As well as Adobe.com. And so people want direct relationships with us, which is good. So all the metrics that we've seen for the business lead us to believe that it's going to be a strong cycle. As you point out, there's pent-up demand, there's digital explosion that we're seeing. And, you know, we'll certainly share more information as we go along. Based on what we've seen so far, it looks to be a strong cycle, which is why I was comparing it with CS3. But it's too early to tell exactly where it's going to end up.

Heather Bellini

Q - Ok, and then, Mark, on the headcount?

Mark Garrett

A - On the headcount. So, you know, I think the way really to look at it is on the margin and earnings line, right. We're very dedicated to those margin and earnings numbers. We will add headcount as we go forward. We're largely adding headcount in, you know, areas that are smart from a geographic standpoint, as well as focused from a business standpoint. So if you look at the heads that we did add, it's primarily in sales and marketing where we're trying to drive revenue, adding more sales capacity in Omniture, adding more R&D headcount where it makes sense. So to make a long story short, yes, you'll see headcount growth. I'm not sure it's going to always be a couple hundred, but you will see headcount growth.

Heather Bellini

Thank you.

Walter Pritchard, Citigroup

Q - Hi, I wondering - just wanted to dive a little bit more into the question around the $5 billion number for fiscal 12. It appears as though, I mean, to keep margins where they are, it would be difficult for you to make even a medium size acquisition to get towards that number. So I'm just trying to get a sense of, you know, backing into it that way, how we should think about M&A as a tool to get to that $5 billion number. And then I just had one quick follow-up.

Mark Garrett

A - Yeah, Walter, it's Mark. One of the big reasons that we said we anticipate margins staying roughly where they'll end up in 2010 is for exactly that reason. We recognize the fact that doing some of these M&A transactions, we're not going to be able to buy businesses that generate the same 35-plus percent operating margins that Adobe does, but we do believe that we can absorb those businesses into our Adobe margin structure and keep the margins at 2010 levels. That's why we thought it was important to give you both a revenue aspiration as well as a margin number.

Shantanu Narayen

A - And Walter, just to add. When we look at the business today, our goal was to communicate that 2010 is clearly off to a great start, and we're very pleased with the execution that we've seen. It seemed to us that the long-term Adobe opportunity that we've had is being sometimes overlooked in this recent Flash controversy. And so it was important for us to really remind all of our investors of the various opportunities that we see. And when you talk about explosion of digital content, the movement towards devices, businesses are moving online, it's just a really massive opportunity, and an opportunity where Adobe is uniquely positioned. And we wanted to clarify that we're really going to capitalize on this opportunity because our customers, frankly, are demanding that we step up, whether it's in the marketing realm. CMOs that I talk to are saying, "Can you please continue to deliver more value for us in visitor acquisition, visitor conversion?" Enterprises are all moving to delivering engaging experiences, and every single publisher has been asking Adobe to extend its offerings to be able to deliver content and help them monetize it and analyze it. It's just a very exciting opportunity for us, and you know, we're going to go execute against it.

Walter Pritchard

Q - And then just a quick question on Enterprise. I think the guidance there was that it was going to be up and it was down sequentially. And I think you mentioned that bookings were up. Was there something between bookings and revenue that was different than you expected?

Shantanu Narayen

A - Well, the Enterprise pipeline that we have is actually a very healthy pipeline. We would expect that as we close the second half of the year you will see sequential significant growth year-over-year. The value proposition is clearly resonating. Some of that is just looking at timing. But in terms of the underlying fundamentals, the business is very solid.

Walter Pritchard

Great, thank you very much.

Phil Winslow, Credit Suisse

Q - Hi, guys. Most of my questions have been answered. But I just want to get a sense for how you guys are thinking about sort of the course for the CS5 cycle. You've given us a sense of the first month, but you also said that you would expect the growth to continue through this year and into early next year. What are the influencing factors, obviously the geographic launches, but what do you all see in PC shipments, et cetera? Thanks.

Shantanu Narayen

A - If you look at the various CS cycles that we've had, you know, the cycles have all been fairly consistent, which is, you know, they start off, you get the early adopters who buy into the products, the people who spend all night waiting for the product. And then you start to see more enterprises adopt it, and you get a network effect, which is when an agency is using it, all their clients use it. And so we would expect in aggregate the CS5 cycle to actually mirror the previous cycles that we have. The level at which we would expect it to exist is higher, clearly, than CS4, given the macroeconomic climate is a lot better. There is pent-up demand. And as you point out, PC sales are clearly one of the indicators that we look at because when people buy new hardware they tend to buy new software. So overall cycle playing out, we would expect it to be consistent with the previous cycles. And we've already seen, frankly, enterprises start to put it through its paces, especially as it relates to taking print content and getting it out to alternate devices.

Phil Winslow

Got it, thanks, guys.

Susan Friar, Goldman Sachs

Q - Terrific, thanks a lot guys. Two questions. Mark, on the margin front, just on the more near term margin look, you talked about Q4 revenue being up sequentially, but margins being about flat with the third quarter. Why wouldn't we get continued leverage as the cycle continues to kick in?

Mark Garrett

A - You know, it really drives back to this concept of driving top-line growth. I mean, we're really trying to first and foremost drive top-line growth and earnings growth. We'll keep margins where they are, and that allows us to invest back in the business - is really the simple answer.

Susan Friar

Q - Got it. But to the extent that you outperform, I'm assuming you'll let that drop through to the bottom line?

Mark Garrett

A - Yeah, that's actually a very good prompt. You know, you guys know us well enough now that any time we over perform in a given quarter you're going to have margin upside.

Susan Friar

Q - Got it. And then a follow-up, Shantanu, kind of talking about how you monetize different pieces. With Flashplayer 10.1 out, you've clearly been working more closely with Google (Nasdaq: GOOG) and places with Facebook, a lot of casual games built on Flash these days. How can you begin to monetize that?

Shantanu Narayen

A - Well I think there are many ways in which we monetize the current Flash platform. First, through the distribution that we have for Flash, and the millions of downloads that we have. As you know, we're monetizing that by providing software services. The authoring continues to be an area of interest for us, and more and more customers are really asking us for multi-screen authoring, being able to deliver their content across multiple devices. We've subleased out to tie (inaudible) analytics in. You're seeing Omniture analytics being increasingly used to track all of the content that's going online. Mobile, as mobile comes online, we're starting to see Omniture analytics used to track mobile content. And finally, streaming, you know. We deliver servers as you know, that allow us to monetize the ubiquity of the Flashplayer. In addition to our enterprise offerings - and the enterprise offering more and more the (inaudible) is really about delivering Flash or rich Internet application experiences through our LiveCycle set of products. So multiple ways in which we are monetizing it today, and we'll continue to do that.

Susan Friar

Got it. Great, thank you.

Mike Olson, Piper Jaffray

Q - Good afternoon. Just one quick question. With Acrobat 10 coming in Q4, people I think often wonder what kinds of additions can you make to a product like Acrobat? And I realize you may not want to give away specific new features, but can you just talk about in general what kinds of things can you do to a product like Acrobat to differentiate the new version? Thanks.

Shantanu Narayen

A - Mike, what we are seeing is a lot of Acrobat usage right now within enterprises to do what we call critical document work flows. The integration of Acrobat and Acrobat.com is a ripe area of innovation and opportunity for us to continue to deliver value to customers. Delivery of PDF files across mobile devices is becoming an increasing use case for us, so you know, multiple innovations are on the drawing board, and we're excited about the new version that as we said will come out later this year.

Mike Olson

Thanks very much.

Phil Rueppel, Wells Fargo Securities

Q - Yes, thank you very much. On the CS5 update, can you talk about some of the features that have been driving, you know, driving demand that maybe were unexpected, and also, in regards to that, the Omniture integration, has that been a key aspect for any sales so far? Thanks.

Shantanu Narayen

A - You know, I would say overall, CS5, when we look at the reviews, the reviews have just been really positive. And in general people talk about the productivity improvements, the performance improvements that we've certainly done. But if you want me to call out some of the things that are clearly getting a lot of customer appreciation, in PhotoShop, features like Content Aware, Phil, are clearly things that people love. In the video products, we completely revamped the playback engine, which is in Premier Pro. Features like Rotobrush and After Effects which enable you, when you have multiple screens, to be able to track an object across that, has got a lot of positive feedback. On the website, some of the services that we have provided, Flash catalyst certainly has also got a lot of positive feedback. And I would say in design, the core assembly products, everything to do within tracking documents, which is taking content out from print and being able to convert it to content for web and now for tablet kinds of devices are certainly gaining traction. But, it's across the board, frankly, the feedback's been very positive.

Phil Rueppel

Q - Great and thanks. And just a follow-up. All the remaining languages, are they due out for release this quarter?

Shantanu Narayen

A - It's all pretty much in market or ready, Philip. So you know, we're there in market with the products. We've been moving towards getting more of the products out as soon as we launch, because frankly, once we announce the product in the US, the anticipation builds and we don't want our customers in other parts of the world to have to wait for the products. The one last thing I'll mention was actually - very quickly after the product as you know, we've also released some updates, including HTML 5 back to Dreamweaver. And that and the services are also seeing a fair amount of uptake.

Mark Garrett

A - Shantanu, along those lines there's a question from the Connect session, and one of them was, are you seeing any impact on the CS business relative to HTML and the Flash debate?

Shantanu Narayen

A - No, we really have not seen any impact of the HTML and Flash debate on our authoring business. I mean, what we are finding, frankly, is that you are seeing more and more fragmented workflows as people have to author to different standards. And the demand actually on our authoring side to be able to deal with all this disbursed workflows is actually causing more attention being paid to the Creative Suite 5 features. And you know we've said this multiple times, the Flash and HTML is really going to be the solution for the Web. Both of them have benefits, and Adobe has had a long history supporting both existing formats, and when the formats don't exist, of inventing appropriate technology to enable people to deliver the kind of experience they want to.

Sasa Zorovic, Janney Montgomery Scott

Q - Yes, so my first question would be kind of going back to the $5 billion in the acquisition. So should we kind of really look at that $5 billion as essentially an organic number with just a little bit acquisitions, just kind of tiny bit good, or should the acquisitions actually might end up providing somewhat of a relatively non-trivial chunk between now and $5 billion?

Shantanu Narayen

A - When we look at our organic businesses, we do believe that they have double-digit growth opportunities, and you know, so you should look at the acquisitions as more small to medium sized M&A. And it's really to fill it out. Let me give you an example of a customer that I recently visited. It's a customer who was using a smattering of creative products. And they found that their entire business was going to move online, and in order to enable them to do that, they wanted not only to get creative across their entire enterprise, but they wanted us to be able to help them publish their content online. They bought Omniture analytics to be able to understand what customers were doing online, and LiveCycle to enable them with that workflow. And so it really is about for the media and publishing customer, how can we provide more of a comprehensive solution, starting with our creative tools? It's for the enterprise customer being able to deliver the engaging experience that they want. So think of it as small to medium size M&A.

Sasa Zorovic

Q - Thank you. And then my second question would sort of competitively with the Omniture, you know, how can you really be sort of where do you see it kind of tying to the CS5 in order to position this product in the market, you know, vis-a-vis a Google or a Coremetrix and you know offerings like that?

Shantanu Narayen

A - The reality is I was expecting somebody might ask us about the IBM (NYSE: IBM) Coremetrix. I mean, Omniture is the clear market leader already in that particular market. And every marketing professional we talk to wants the ability to start from the creative process and that intelligence in it that they allow to be analyzed later on. So Sasa, what we have done with Creative Suite 5 is to start to show the vision of when you do the creative process, being able to imbed the intelligence so that you can automatically then analyze the data when it moves online. Customers are pleased with it. They've all had to build their own analytics capability around Flashplayer, and now we're able to do that for them in a unified and consistent fashion.

Sasa Zorovic

Thank you very much.

Kash Rangan, Merrill Lynch

Q - Hi, thank you very much. Just a quick question. I think Mark had talked about investing in headcount as the quarter progressed. And I'm just curious if you can give us a little bit more color into it. What are you seeing in the marketplace that is causing you to step up your base of expenses, and which product areas are you investing in that we (inaudible). And finally, what kind of timeline would we see between this going in place and seeing the revenue acceleration that you had hoped for from this (inaudible)? Thanks.

Mark Garrett

A - OK, Kash. You know, from a headcount perspective again, you know, it's really to help drive top-line revenue growth. That's first and foremost our priority. So a lot of the headcount is going into the field in sales and marketing, particularly around areas where we see large growth opportunities like the Enterprise and Omniture specifically. So you know, again, it's really first and foremost to help drive revenue growth. So to the extent that we believe the revenue growth is out there, we'll invest to get that revenue growth. And I'm not sure I caught the second part of your question.

Kash Rangan

Q - The timing of when you would expect to see the revenue inflection based on the headcount increase that you're putting in place now?

Mark Garrett

A - We kind of gave you what we think that revenue inflection looks like over the next few years and trying to get to $5 billion in 2012. If we're going to do that and we're committed to doing that we've got to start to put the pieces in place. And some of that's organic and some of that's inorganic like Shantanu talked about, but on the organic side we need the capacity to drive that revenue.

Shantanu Narayen

A - One other thing I might add, Kash, is that's clearly also dependent on the kind of business. For example, with Omniture we can tell you that we're ahead of our plans with respect to the annual contract value and the bookings, which is the internal way in which we measure the business and the metric we use to signify strength in that business. That doesn't get reported out immediately as you know because that's revenue that we recognize ratably over the duration of the contract. So, just realize that some of the investments that we're making reflect in booking and not necessarily in reported revenue right off the bat.

Mike Saviage

Q -Along those lines there is another question in the Connect session about the $5 billion aspiration in 2012, and one of the questions was related to recurring revenue: Do we expect the growth of the business to continue to focus on recurring revenue-type businesses?

Mark Garrett

A - Yes, I'll take that Mike. Yeah, we do. Like I've said in the past we take our recurring revenue from what was 5% in 2005 to what will be close to 20% if you look at it this year. And I fully expect as we look at some of these technology companies that we're going to acquire, they'll be more ratable revenue models. We'll continue to drive more ratable revenue with new businesses on our own, so together, yeah, I think we can clearly expand the ratable portion of our revenue.

Dan Cummins, Thinkequity

Q - First one for Mark, if you could just review the math behind your expectations for - I'm not sure exactly what the word was - a modest quarter-on-quarter revenue growth in Creative Solutions. Given a full August quarter versus a partial May quarter, are you just being conservative? Is this currency or European seasonality? And then, for Shantanu, I just wanted to ask about the market for content servers and what your big Flash content server customers are signaling with respect to what's happening with Apple. The transaction server number - I'm not sure the exact economic meaning of that number - it just looks kind of mild here versus the recent past. Thanks.

Mark Garrett

A - So on the guidance keep in mind that my comments were relating to the mid-point of the guidance, so the the extent that you believe we would come in at the higher end of the guidance, the difference between the midpoint and the high end is going to be driven by Creative. But you're right, there's clearly seasonality in Europe, and we're trying to anticipate that. We've got back-to-school which helps offset some of that. We think we'll have some government growth in the government channel. And kind of when you net all that out, we think Creative, at least at the midpoint of the range, grows slightly. We'll see growth in Enterprise and Omniture and like I said Knowledge Worker and the print businesses relatively flat. But again, to the extent that you're above the midpoint, you'd see more strength on the Creative side.

Dan Cummins

Q - Is there a nominal new headwind number that's kind of already built in on non-currency?

Mark Garrett

A - No. So we assume rates stay where they are, and like I had mentioned, we do have some hedging benefit that we'll be able to take in Q3 and Q4 that totals about $30 million in the back half of the year.

Shantanu Narayen

A - With respect to your question on the content servers, when we think about the amount of videos served or streamed using the Flash format, that is actually exceeding our expectations at the beginning of the year. And it just reflects that more and more video, frankly, is being streamed over the Internet. The fact that some formats don't support it just means that they may be alternate workforce (inaudible). When you think about sporting events that are happening or when you think about television, all of that's also being streamed on the Internet, and frankly, all of that's on Flash. So for those who've been watching the soccer or golf, virtually all of that content is in Flash.

Ross MacMillan, Jeffries & Co.

Q - Thank a lot. Most of mine have been answered but I had a couple. First is just when we look at the CS3 versus CS5 cycle, you had a pretty strong first quarter here with CS5. And in fact if I adjust for currency, the sequential is probably quite similar to that seen in the first quarter of CS5. But the subsequent quarter with CS3 was another very strong sequential, which seems to be quite different from what we're describing this time around. Is that just a function of the timing of the language releases, or is there anything else playing into that? In other words, the more sequential in the second quarter of release this time around compared to CS3?

Mark Garrett

A - Ross, it's Mark. Yeah, I think a large part of that is what you just said which is, if you remember back in CS3 we timed out the launch, and in CS5 it all came out at one time, like Shantanu said.

Ross MacMillan
Q - Great, and then just housekeeping really. On other income, did you make a call at, Mark, as to what you thought the other income would look like in Q3?

Mark Garrett

A - Yeah, I did. I said it would be somewhere between $12.5 million loss to a $13.5 million loss.

Ross MacMillan

That's it for me. Thanks.

Steve Ashley, Robert W. Baird

Q - My questions relate to mobile devices and whether you think that new functionality within the CS5 offerings related to mobile and authoring for smaller form factors is having impact on demand during this product cycle?

Shantanu Narayen

A - Again, Steve, I would say that the CS5 product has been so strong across the board, mobile and I would say authoring, frankly, from multiple screens is clearly one of the features that we're getting more demand and request from, because it's a pinpoint that's here and now for all customers. And I think you'll see, frankly, probably another ten tablet-style devices that come out with different resolutions between now and holiday season, which will actually increase the demand for that capability within our products. And so, yes, the need from customers to be able to get their content out to multiple devices, we've certainly seen an uptake in that request.

Steve Ashley

Thank you, that's it for me.

Chad Bartley, Pacific Crest Securities

Q - Thanks, just a clarifying question from me. I think in the script you talked about CS5 and then maybe Flash in some way, shape or form, and you talked about 22% growth and 59% growth. Could you clarify what you guys said there?

Shantanu Narayen

A - Sure. What we had said was in the number of Flash developers that we have seen, you know, creative people as well as developers year-over-year, it's now up to 3.5 million creative designers and developers, which was a 59% increase. In terms of the revenue of the products that contain Flash, we had talked about 22% increase in revenue.

Chad Bartley

Q - So should we compare that to the 15% overall for the CS5 in the early 5-6 weeks?

Shantanu Narayen

A - That's correct.

Chad Bartley

Great, thank you.

Philip Dionisio, FBR Capital Markets

Q - Hi, this is Philip for David. Going back to Omniture, could you talk about the enterprise retention rate? It looks like it ticked down, and what did you see there? And then when you compare the first five weeks of CS5, how did that compare to the first five weeks of CS3?

Shantanu Narayen

A - So let me take the first question, which was around Omniture. When we look at the Omniture business, we look at it actually by even more segments. And we look at it as what are the strategic customer accounts, what are the key customer accounts, what are the major and what are the mid-market. And when we think about the key and the strategic - and a lot of this is driven, frankly, by what the annual contract value is for each of these customers. And the key and strategic, we had closer to 100%, in fact it was 100% retention rate. Where we've seen a slight dip down is actually in the mid-market, and the small and medium business. But in the larger enterprise, business continues to be very strong. And your second question was about CS5 and CS3. Again, as we said, we expect over the cycle it's going to be closer to CS3. It's been a strong product launch. We're excited about it. It's early to draw too many conclusions.

Philip Dionisio

Q - Is it safe to say that the first five weeks of CS5 we're close to CS3 - the first five weeks of CS3?

Shantanu Narayen

A - Yes, it's safe to say it was close.

Philip Dionisio

OK, thank you.

Blair Abernathy, Thomas Weisel Partners

Q - Thanks, just a follow-up on the LiveCycle business. I'm wondering if you can just give us a better sense of the market conditions there. I know the results were kind of flattish again this quarter, but you sound on your prepared remarks you're a little more bullish about that business. And can you also expand on where you are with partnerships in that business?

Shantanu Narayen

A - Sure. The reason we're bullish about it is because we have more visibility into the pipeline, frankly, and when we're talking to customers about delivering these customer experience solutions, it's clearly resonating with these customers. And so that gives us optimism about the second half and our ability to close that. With respect to your second question on -

Blair Abernathy

Q - Partnerships.

Shantanu Narayen

A - Partnerships. We continue to actually get a fair amount of revenue - what we call partner source revenue as you recognize in the enterprise space. That's a way of expanding your ecosystem, and that continues to be healthy for us. And that's both systems integrators as well as ISVs.

Blair Abernathy

Ok, thank you.

Mike Saviage

So with that we'll close our call today, and we thank everyone for joining us.