Adobe Inc (ADBE) 2002 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Adobe Systems quarter 3 fiscal year 2002 earnings conference call. Presentation participants will be in a listen-only mode. Afterwards we will conduct a question-answer session. At that time if you have a question, please press the one followed by the four on your telephone. As a reminder, this conference is being recorded Thursday, September 12th, 2002. I would now like to turn the call over to Mr. Mike Saviage, Senior Director, Investor Relations. Please go ahead, sir.

Good afternoon. Thank you for joining us today. Joining in the call are Bruce Chizen, our President and CEO; Murray Demo, Senior Vice President and CFO, and Shantanu Narayen, Executive Vice President of Worldwide Products.

The call today will discuss the financial results for our third quarter of fiscal 2002. By now you should have a copy of our Q3 earnings press release. This crossed the wire about 20 minutes ago. If you still need a copy of the press release you can go to Adobe.com, under the company info, and press links to find an electronic copy.

Before we get started, I want to emphasis that some of the information discussed in the call contains forward-looking statement that involve risk and uncertainties. Actual results may differ materially from those set forth in such statements. For a discussion of the risks and uncertainties, you should read the [inaudible] filings, including the end report on form 10-K fiscal year 2001 and quarterly reports on form 10-Q filed in fiscal 2002. All participants are advised that the audio of this conference call is being broadcast live over the Internet. It's also being recorded for playback purposes. The audio of the call will be archived in our investor relations website for approximately 30 days and is the property of Adobe Systems. It will not be re-recorded or otherwise reproduced or distributed without prior written permission from Adobe Systems. I'd now like to turn the call over to Bruce.

Thanks, Mike. I am pleased to announce today that Adobe is reporting revenues and earnings which are on the high end of our revised ranges that we provided in our intraquarter update on July 31. Revenue in Q3 was $284.9 million and pro forma earnings per share were 22 cents.

Since July 31st we saw a rebound in our U.S. business primarily in the education market and with incremental revenue from the launches of new versions of Photoshop Elements and Adobe Premiere. It continues to invest in our e-paper business, our largest growth opportunity. We've made progress with the Accelio integration and are gearing up for several e-paper solution product launches starting later this year. In a few minutes Shantanu will provide business segments highlights for the quarter, but first I'll turn it over to Murray for a review of our financial results. Murray?

Thanks, Bruce. For the third quarter of fiscal 2002, Adobe achieved revenue of $284.9 million. This compares to $292.1 million reported for the third quarter of fiscal 2001 and $317.4 million reported last quarter. GAAP net income for the third quarter of fiscal 2002, which includes nonoperative gains and losses, was $47.2 million compared to $40.3 million reported in the third quarter of fiscal 2001 and $54.3 million last quarter.

Pro forma net income which excludes the amortization of goodwill acquired in process research and development with structuring and other charges and investment gains and losses from the company's venture programs was $52.5 million compared to $69.1 million reported in the third quarter of fiscal 2001 and $67.4 million last quarter.

Pro forma diluted earnings per share for the third quarter fiscal 2002, which excludes the amortization of goodwill and the investment loss in the company's venture programs, were 22 cents. The undiluted per share for the Q3 of fiscal 2002 were 19 cents based on 243.4 million weighted average shares. This compares with diluted earnings per share of 16 cents reported in the third quarter of fiscal 2001 based on 248.6 million weighted average shares and diluted earnings per share of 22 cents reported last quarter based on 247.7 million weighted average shares.

Gross margin for the quarter was 88.9 percent, compared to 93.1 percent in the third quarter of fiscal 2001 and 92.1 percent last quarter. Gross margin was lower than target primarily due to a $5.5 million dollar apt [phonetic] impairment charge for Faz [phonetic] 121 for capitalized Adobe studio web development costs.

Excluding the amortization of goodwill, pro forma offered expenses for the third quarter of fiscal 2002 were $180.2 million. Pro forma operating expenses in the third quarter are lower than last quarter primarily due to lower marketing expenses and lower incentive compensation.

Regular employees at the end of the third quarter was 3,557 versus 3,510 at the end of the second quarter of fiscal 2002. Expenses as a percent of revenue break down as follows. Research and development, 21 percent. Sales and marketing, 32.9 percent. GNA, 9.4 percent. Excluding the amortization of goodwill with structuring and other charges and acquired in process research and development, pro forma operating profit in the third quarter of fiscal 2002 was $73 million or 25.6 percent of revenue. This compares to pro forma operating profit of $96.4 million or 33 percent of revenue in the third quarter of fiscal 2001 and $96.4 million or 30.4 percent of revenue last quarter.

Other income for the third quarter of fiscal 2002 was $4.1 million. Other income this quarter was higher than target due to gains on the sales of fixed income investments.

Adobe's effective tax rate for the third quarter of fiscal 2002 was 32 percent compared to 33 percent in the third quarter of fiscal 2001 and 32 percent last quarter.

I will now discuss Adobe's revenue by market segment. Graphic segment revenue was $118.2 million in Q3 fiscal 2002 compared to $125.5 in Q3 fiscal 2001 and $153.6 million quarter last quarter. The reason for the sequential decline was lower Photoshop revenue. Cross media publishing segment revenue was $64.4 million in Q3 fiscal 2002 compared to $66.4 million in Q3 fiscal 2001 and $67.1 million last quarter.

E-paper solution segment revenue where we now include Accelio, was $78.6 million in Q3 fiscal 2002 compared to $74.3 million in Q3 fiscal 2001 and $75.6 million last quarter. Revenue from the acquired Accelio business was $8.8 million this quarter. Also I would like to point out that beginning this quarter we are separating out our Accelio related service and support revenue and direct costs on the income statement. OEM [inaudible] other segment revenue was $23.7 million in Q3 fiscal 2002, compared to $25.9 million in Q3 fiscal 2001 and $21.1 million last quarter.

Turning to revenue by geographic segment, the results in Q3 fiscal 2002 were as follows: The Americans, 55 percent. Europe, 24 percent. Asia, 21 percent. As Bruce stated earlier, since our intraquarter update on July 31st, we saw a rebound in our U.S. business, primarily in the education market and from the launch of new products.

In Europe the weakness we experienced in July continued for the first half of August but then improved in the last few weeks of the month, consistent with typical seasonal trends. And in Asia the weak demand in Japan that we experienced in July continued through August.

Applications for platform mix was 72 percent Windows and 28 percent Mac in the third quarter of fiscal 2002 which compares to 71 percent Windows and 29 percent Mac for the third quarter of fiscal 2001 and 59 percent Windows and 31 percent Mac last quarter.

Our trade DSO in the third quarter of fiscal 2002 was 46 days. This compared to 46 days in Q3 fiscal 2001 and 38 days last quarter. DSO was higher this quarter due to stronger revenue in August. Our global inventory position at the end of the quarter continues to be within company policy. At the end of the third quarter fiscal 2002, cash and short term investments were $636.2 million compared to $699.9 million at the end of the second of fiscal 2002.

Turning to Adobe ventures, we incurred an investment loss of $4.2 million in Q3 fiscal in 2002. In the quarter we made additional investments of $3.7 million. In total, Adobe has invested $208.6 million through its venture partnerships and direct investments. As of the end of the third quarter, the net returns in this program were $344.8 million including a stock dividend to stockholders and the market value of investment still held by Adobe.

In regard to share buyback, Adobe repurchased approximately 2.9 million shares at a cost of $89.7 million during the quarter as part of its ongoing share repurchase program to offset dilution from employee stock programs. In addition, as part of the company's separate 5 million share repurchase program, Adobe repurchased approximately 1.2 million shares at a cost of $21.4 million during the quarter.

Adobe's board of directors declared this quarter's cash dividend of 1.25 cents per share payable on October 8, 2002, to stockholders of record as of September 24th, 2002. This concludes my discussion on third quarter fiscal 2002 results.

I would now like to discuss our Q4 fiscal 2002 targets. We are targeting revenue of $285 to $300 million. As a percent of revenue, our approximate operating model targets for the quarter are as follows: Gross margin, 91 percent. R and D, 21 to 22 percent. Sales and marketing, 32 to 34 percent. GNA, 9 percent. Resulting in an operating margin target of approximately 26 to 29 percent. For a share account we are targeting a range of 240 to 242 million shares.

Finally, we are targeting other income of approximately $2 to $3 million at a tax rate of 32 percent. These targets lead to a pro forma earnings per share target range in Q4 fiscal 2002 of 21 to 25 cents per share.

This concludes my comments. I will now turn the call over to Shantanu.

Thanks. I'll spend the next minutes reviewing our business, starting with e-paper. The biggest opportunity for Acrobat is to obtain rapid penetration into the enterprise. A key focus area for Adobe is to increase awareness among general business users of the benefits of the full version of Acrobat. We continue to make significant investments in sales and marketing against this opportunity.

In regard to Acrobat results in Q3, we saw a sequential increase in quarter over quarter revenue in the U.S. market. In addition, we continue to see significant licensing procurements of Acrobat from major corporations as well as government institutions. Deals with greater than 2500 seats in the quarter included Merck, Siemens, Pfizer, the U.S. Department of Justice, and the U.S. Department of Defense.

The other major opportunity with our e-paper business is providing complete solutions for our customers in the areas of electronic phones, e-presentment, and business automation.

In the government market, EDUs based on our cellular service solutions included the commerce commission in the State of Illinois which is automating business applications and permits for trucking company through e-phones. The State of Michigan, which is automating phone processes will state daycare providers and health insurance and the Department of Veteran Affairs, which is automating the clear processing for all U.S. military veterans.

In the enterprise market, key wins with our service solutions included Citi Mortgage, which is automating their mortgage application and customer reporting process with Adobe e-presentment solutions; Bright Horizons, a leading provider of employer sponsored childcare which is utilizing Adobe e-phones and business process management to streamline their internal HR functions; and CIBC which is automating their call center processes using Adobe e-phones solution.

As part of our extension into the enterprise, we continue to add expertise across the organization. In addition to key hires in our field and marketing teams, we are excited about the recent edition of Ivan Coon [phonetic] as the Senior Vice President of our e-paper business and a new member of our executive team.

turning to our graphic segment, I would first like to comment on our Photoshop business. While worldwide operation for Photoshop 7 have been consistent with what we experienced with Photoshop 6, we saw a decline in the full unit business when compared to historic Photoshop release patterns. We attribute this to the continued global economic weakness impacting creative professionals and high end consumers.

Highlights in our graphics segment include the shipping of two exciting new products in the quarter. Photoshop Elements 2.0, which was released in August, offers a number of enhancements and supports our strategy to expend Adobe's digital limiting franchise to the mid range of this market. Elements takes advantage of the strength and the Photoshop brand and the exclusive growth in digital photography. Early reviews for Photoshop Elements have been excellent. The New York Times stated, "Elements is a spectacular value." In Parade magazine, with a circulation of 37 million, stated that, "Elements is advanced, yet user-friendly. And an affordable way to make your photographs look great."

We hope to ship Premiere 6.5 during the quarter, a new version of our award-winning digital video product. Premiere provides a complete anything environment to produce professional, high quality video for DVD, CD-ROM, and the web and keeps us positioned as the leading provider of professional digital editing software.

Finally in our graphic segment this week we announced Adobe Graphics Server 2.0, formally known as AlterCast. The new version dramatically reduces the time and cost of creating and updating images by automating image production tasks and integrating easily with asset management and e-commerce applications. It will ship later this year.

Turning to our cross media segment, InDesign continues to gain momentum through standalone InDesign and Design Collection Adoption, we are gaining market share. During the quarter we closed new InDesign licensing business with Random House, Office Max, Knight-Ridder, and BMW. Reed Severe [phonetic], a world leading publisher of many popular magazines, has successfully moved two magazines from core [phonetic] to InDesign.

In the education market we secured business with the Rhode Island School of Design and the University of Wisconsin. Other highlights included decisions by the California College of Arts and Crafts and the Ringling [phonetic] School of Design to incorporate InDesign into their curriculum beginning in the fall.

Finally, InCopy is an important component to the adoption of InDesign in the newspaper and magazine publishing markets. We were particularly pleased that the newly released InCopy 2.0 was named the hard pick at the Seebold [phonetic] San Francisco trade show this week. This concludes my Q3 business segment review. I would now like to turn the call back to Bruce.

Thanks. While global economic environment remains challenging, we are optimistic about our business. The revenue targets we are providing today call for growth on a quarterly and annual basis in Q4. We are looking forward to presenting Adobe's strategic direction at our upcoming financial analyst meeting in October. During that meeting we will focus our directions on three primary areas: The growth opportunities with Acrobat and e-paper solutions in the enterprise, extending Adobe's digital imaging and digital video businesses, and continuing to serve the needs of the creative professional customer with enhanced solutions. We will continue to balance the needs of being a highly profitable company in the short term while making the right long-term investments necessary to fuel Adobe's future growth. ?

Thanks, Bruce. Before we start the Q and A session, I'd like to remind everyone that our fall financial analyst meeting that Bruce just mentioned is in the afternoon on Monday, October 28th in New York City. Details, including invitations and registration information, will be sent out soon. Our regular intraquarter update for the fourth quarter will be issued as part of our analyst meeting that day.

For those who wish to listen to a playback of today's conference call, an audio recording of the call will be available from Adobe's investor relations website on Adobe.com later today. Alternatively, you can listen to a phone replay by calling 402-977-9140. Use reservation number 20853836. Again, the phone number is 402-977-9140 with reservation 20853836. The phone playback service will be available beginning at 4 p.m. Pacific time today and ending 4 p.m. Pacific time Monday, September 16th, 2002.

We will now be happy to take your questions. Out of courtesy to others on the call, we ask that you limit your questioning to one per person. Operator?

Thank you. Ladies and gentlemen, if you'd like to register a question, please press the one, followed by the four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the one followed by the three. If you are using a speakerphone, please lift your handset before registering your request. One moment, please for the first question. Our first question will come from Ben Reitzes with UBS Warburg. Please go ahead.

Good afternoon, guys. I wanted to ask a question and I need a classification. One is with regard to the fourth quarter in your outlook for flat-top revenues, what is the driver? Can you give us a little bit more what we should be looking for on the product roadmap maybe by segment, is there certain geography and whatnot? Both product and seasonality detail will be helpful.

And then clarification did you say there would be new Acrobat products in the fourth quarter? Did I hear that right? And what did you mean?

Hey, Ben, This is Murray. I'll go ahead and tackle the first one. In regard to the sequential increase in the fourth quarter in terms of the range of 285 to 300, there's sort of three points there. First of all, we're assuming no change in economic conditions. Secondly, we are factoring in a seasonal pickup in Europe like we've seen in past years, and that's a momentum in e-paper. Again Acrobat and Accelio we will see an improvement in the fourth quarter.

Ben, with respect to the new Acrobat products, acquisition of Accelio, we are starting to look at the service solutions that they have and we've previously talked about service solutions. With respect to the Acrobat desktop product, you know, we don't announce new products, but if you look at historical trends, we've traditionally been on a two-year cycle and the last release was in Q2 of '01.

And what does it assume your outlook for Photoshop, Murray?

We're not giving any specifics on that, but we would expect at least in Europe because of the seasonal pickup that would impact all products across the board in Europe, so that would be advantageous for Europe but we're not providing anything specific on those products at this time.

And what did you say, you had new Acrobat solutions by the fourth quarter, Bruce, you mentioned in your opening comment, maybe the second thing you said?

BRUCE CHIZEN: Yeah, what Shantanu was referring to I mentioned briefly. We've been talking about a number of server product in our e-paper business to take advantage of the more than 400 million readers, Acrobat Readers we have out there as well as the Acrobat technology. We've seen some technology demonstrations of some of the servers that we've been working on as well as we've been making modifications of the Accelio service. What you can expect in the fall time frame is supposed to announce a number of solutions incorporating some of the technology that we've been alluding to, and those will be announced and many of them will start shipping later this fall.

Sorry there, but this is not a new application, an application a little later on?

BRUCE CHIZEN: I'm not sure what you're - as far as we're concerned it's a new application to solve customers requirements. It's not a desk top application requirement; they're server based solutions or server based application.

That's what I mean.

BRUCE CHIZEN: As far as we're concerned they are absolutely new applications.

But it's not the new desktop application, not a version 6.0?

BRUCE CHIZEN: No, and I think Shantanu has hinted in so many ways if you do the math, you're probably looking at Q2 of '03.

Thanks a lot, guys.

Our next question will come from Jay Vleeschhouwer with Merrill Lynch. Please go ahead.

Good afternoon. Couple of questions. First on Photoshop, Bruce, did Photoshop in the third quarter revert to the pre version 7 levels of revenue, in other words, did you pretty much get back in the early all of the sequential increases that you got in the May quarter with version 7 release?

And with respect to the weakness you're talking about, at least the new units, to what extent have you considered this might be a legacy product issue and not just an economic issue, that is, are we talking about a rather elderly product at this point and so is that at all a consideration?

Secondly, you ran some price promotions or promotions in the third quarter, mostly around bundling the training and services with the product. Did that have any material benefit in the quarter?

And then finally for Shantanu, are these new server applications you're introducing in the fourth quarter traditional software sales, in other words, perpetual licenses, or are you pricing it on some kind of a usage base server model?

I'll try to answer the first part of that question. In regards to Photoshop, if you look at the overall level, as we stated earlier that from an upgrade standpoint Photoshop 7 is basically on par with Photoshop 6, and it's on the full units where we've seen the challenge. If you look at the overall Photoshop revenues, Jay, in the third quarter, we haven't given back all of it, but we've given back a majority of what we stood before the release.

BRUCE CHIZEN: I think Shantanu will talk about the details, but we certainly don't think of Photoshop as an elderly citizen, to use your words. The market opportunity for that product continuing to get larger and larger, and I think Shantanu has some specifics.

Okay. I'll go on to the first question, Jay. I think in the digital imaging market, the creative full market we certainly have seen the economy in fact the creative pro market, and we've talked about that. And I think in terms of new unit expansion, I think that's been impacted by what we've seen in the economy, and we've also talked about an additional impact with respect to Japan. However, we continue to believe the impact of Photoshop is beyond just the creative pro market and in fact we are seeing more and more adoption in other markets adjacent to the creative pro market.

Also you have to remember that when we talk about Photoshop, we're talking about Photoshop unit sales and there's also the impact of collections and then the creative pro market, we do continue to see our collections revenue increase and in fact people gravitate more towards the collections rather than individual point products because they don't create complete solutions.

And I think you're seeing the effect of our other digital imaging products across the other segments continue to increase. So that's a little more color on Photoshop.

With respect to the new server applications, we're not announcing pricing today, but clearly for CPU pricing, as is prevalent in a lot of the enterprises, will be if the norm for some of those. And for the other product that we've alluded to in the past, namely having people use the Acrobat Reader as a platform to make functionality appear, there, yes, we are looking at it on a per use model. It's some of both.

Regarding the Q3 promotions, those are normal marketing incentives, marketing promotions, certainly some of the uptake we experienced in the U.S., probably has some correlation with giving our customers an easier way to get into our product, via training materials and books and things like that. But it's nothing out of the ordinary. That's something that we do on an ongoing basis. Q3 we'll probably be a little bit more aggressive than usual because that's because we have the new products, combination Q2, Q3.

Thank you.

Our next question will come from Craig Ellis with Saloman Smith Barney. Please go ahead.

Thank you, just digging into the fourth quarter gross margin a little bit, I know that in the last strategic update we talked about changes in the field structure and transformation there. Should we look at that as requiring increased levels of investment versus what we saw in the past and is 91 percent gross margins a better proxy of what we should look for going forward or is that just a stopping point on the way back up to what we've seen recently in the 92 and 93 percent range?

In regard to the direct cost, there's a couple of things there. First of all, some of our direct costs are fixed in nature, so they're independent of revenues. So Depending on what the revenue level is, we get leverage on those costs in terms of the higher margins. So in terms of trying to look at revenues all we're talking about right now is the fourth quarter of the 285 to 300 range and that's where the 91 percent target is coming from.

In past years we've had higher levels of gross margins. That was also dependent upon higher levels of revenue. So again, we'll come back for leverage on those fixed costs. So right now all we're targeting is the 91 percent for the fourth quarter. Also if you, again, if you were to do the math on the charge you took this quarter, the $5.5 million impairment charge if you were to add that back in we would come in around 90.8 percent, so that's pretty similar to the targets we're providing for the fourth quarter.

In terms of the future, Craig, that's something we're not prepared to address today.

Okay, fair enough. Thanks, Murray. Thanks, Bruce.

Our next question will come from John McPeake with Prudential Securities. Please go ahead.

Thank you, guys. Good quarter. I have one quick question or two question, so I'll violate the rule too. At the analyst day, how much guidance do you think you're going to be prepared to give at that time? Are you going to give us a look at what you think next year could be?

If we have visibility, John, we'll provide it. If we don't have visibility, we won't provide it. I can't sit here today and know what it's going to look like at the end of October. We're certainly going through our planning, but I think as we've demonstrated this last year, prying to predict revenue in an uncertain economy is something we're not very good at.

Enough said.

If you think we could be good at it, we'll do it.

That's fine. And so far in September, I know you guys have sort of a 48 hour ability to roll numbers up. are you seeing the same type of trajectory in Europe, and could you comment specifically on Photoshop 7 in Europe?

John, we're not providing any information on the fourth quarter at this point. Yes, we do have information since the quarter began, but we're not providing anything. We'll do that at the intraquarter update at the same time we have our analyst meeting in October.

But the information you have makes you feel pretty good?

The data we do have was certainly factored into the guidance I provided you with.

And then finally, could you give us some kind of an update, Shantanu or somebody, with respect to what you think the install basis and seats for Acrobat right now?

For the Reader, we've said it's 400 million. For the full product, we're going to be giving an update in the analyst meeting.

Okay. Three misses.

What I can say is the outside is great.

Okay. Thank you.

Our next question comes from Dani Hunt [phonetic] with Dain Rauscher. Please go ahead.

Great. Thank you. I'm going to try to stick to one question so we'll see how I do. Seems like just an interesting quarter, you kind of zigged and zagged the tree in the beginning and then it poofed towards the end [phonetic]. I was wondering if you could give a little more color. You said education came on stronger at the end. Was that in any specific product line? Was that more graphics or e-paper? And then also talk about like relative was retail stronger? I mean, most of the retail numbers were pretty bad and I know there's some component of your business that does go through retail. How does that look? And then I've got one follow-up question.

With regards to the U.S. in August we saw this pickup in education throughout the month. It wasn't, you know, right at the end of August. It was throughout the month of August. We also saw a pickup in the shrink wrap business generally across the board and also that had to do with the shipment of Photoshop Elements and Premiere in the month of August. So it was, you know, a little abroad [phonetic]and it was strong on education and again, it was driven by the Elements and Premiere as well.

The other thing I would point out is our Acrobat licensing business on a worldwide basis was up on a sequential basis.

Could you say in terms of your [inaudible] inventory and policy, was it up, down, or neutral on a sequential basis?

I can tell you it was within 1/100th of a week of last quarter.

And one final thing. Asia continues to kind of deteriorate. Do you get the sense we're not the bottom at this point or kind of continue to, you know, continue to decline sequentially?

What we saw in August was basically the same as what we saw in July. As we all know, September is typically a stronger month in Japan because it's the semi annual period begin so we would expect to see September up in Japan and then October a weakness as some of that revenue moves from October into September, but at this point, as I said earlier, we're assuming no change in economic conditions around the world so that would hold for Japan as well.

And for the benefit of others keep in mind Adobe is the bulk of our Asian business is from Japan.

Great Thank you very much.

Our next question will come from Solin Cho. Please go ahead.

Hi, thank you, just a couple of questions. First, I will ask a couple in different kinds of ways, but the pickup you saw in August, was that primarily due to typical seasonality? Because as I understood it you do see typical seasonal education related pickup and some pickup at the end of August in Europe as well. Was there something outside of just the typical seasonality plus the new product introductions that might have accounted for the improvement in August?

Well, Solin, in terms of the seasonality, it was pretty much right on track. You know, Europe was probably about a week later than last year, but it picked right up the last two weeks like we would expect. And the U.S. we saw the same seasonal impact as well both in education and our overall business as well as, again, the new products. So it comes down to this magnitude on the seasonal trend and you know, the range we've given of 270-290 I would assume if it came in toward the heart of the range, things would be better in August; and if things remain flat from July then we'd be towards the bottom of the range. So we definitely saw the seasonal pickup and it was nicely strong.

But nothing, no commentary in terms of the underlying, no changes in terms of the underlying demand or dynamic; it's more just that you saw the seasonality that you typically see and you gave a range and it was toward the high end of the range as far as typical seasonality.

For the most part, yeah. We've been making an investment in the education market over the past three years for two reasons. One is we do think it was a good revenue opportunity for Adobe. But there is also a strategic component that as we get more of the kids using our products and curriculum that as they move out of the university market into the work force or workplace, they'll take that knowledge with them. Certainly a key strategy with InDesign and one we just started with Acrobat. So we did see a bigger growth in education on a year-over-year basis than certainly we saw for the rest of our business. But if you look at the holistically, what Murray said, is from a holistic view is accurate.

One other question. If you X out Accelio it looks like the base Acrobat business was down sequentially. I apologize if you already answered this. But for the fourth quarter have you built in a pickup over the third quarter; and if so, you know, what's the basis of that type of an expectation?

Well, first of all I just want to note that the overall e-paper business inclusive of both Acrobat and Accelio was up on a sequential basis. The decline in the Acrobat business from $74 million to $70 million if you factor in the seasonality, we're pleased, and we believe that that is an indicator and we are planning for sequential growth in Q4 in our Acrobat business.

The other, I think Shantanu mentioned earlier on in his prepared comments that our U.S. business actually grew sequentially. So where we saw the shortfall, but the decline of Acrobat were in the other two geographies. So we look at it as good news. The 74 to 70 would suggest we should have a pretty strong Q4 in our e-paper business.

Okay. Great. Thank you.

Our next question comes from Peter Ausnit with Deutsch Bank Securities. Please go ahead.

Thank you. Give us some detail on your large deals. I think you had six deals larger than 2500 seats. Can you tell us how large your largest deal was and give us some sense of the mix of revenues from the enterprise and public channels?

What we try to do with the customer examples we give is to use them as examples and just as an indicater that the buying and licensing of Acrobat continues to be a significant piece of our business and important piece of our business, and we're doing that as an illustration that we're making progress. What we prefer not to do - in fact our customers would probably be pretty upset with us if we went and talked about their businesses and how they see their licensing [phonetic].

What is important to note is even though the Acrobat business declined on a sequential basis, the licensing business for Acrobat actually increased on a worldwide basis. But if you look at some of the things we've said historically we've had deals, 50,000 seats, 160,000 seats, it's all over the map. In some cases it could be a law firm that only has 2500 employees and has 2500 seats or it could be a large telecom company with 100,000 seats. So really it varies by entity. So the fact that these organizations are buying at least 2500 units on a license or a buy-in basis is hopefully a demonstration that organizations are committed to Acrobat on their desktop.

Just generally the percentage of Acrobat revenue is coming from the desk, excuse me, from the enterprise. Could you give us some sense of that; is it 10 percent, is it 25 percent?

The challenge for us is we don't know how many organizations are meeting their Acrobat requirements by buying the shrink wrap product versus the licensed product. So for me to give you a specific license number as a percentage would not be a clear indicator of what that total business is. Because a lot of organizations that even though buying a license could be more price efficient, it's easier for them just to buy a shrink wrap product directly through a resaler in a high volume. So it's hard for us to see and varies geography by geography. As you go outside the U.S., licensing is less interesting to most customers.

Okay. Let me ask a different question. You said that education really drove a lot of the better than expected - drove you to the high end of your range this quarter. Could you give us a sense of how big the education market is as a percentage of your total revenue?

We have not provided that number. It's not like the majority of the business or anything. The ASPs on those products are much lower, so it's an important part, but it's not a, you know, major portion of our revenue.

So you take a single digit as a percentage?

Again, we're not giving any specifics, but it's not, you know, a significantly large number by any means.

All right. Well, thank you very much.

Our next question comes Mr. Chris Galvin of JP Morgan. Please go ahead.

Thanks. Wondering if there's been any changes in terms of the longer term business model with Photoshop with some of the success of Photoshop Elements. I saw one review which talked about its functionality getting very close to the full product, which may be stealing some business from the full product and taking it down to the lower end product with a lower price point. So some commentary on that would be helpful. Thanks.

Chris, the way we look at the digital market again, we just continue to believe that it's going to get driven by the trends that we see, digital cameras, digital videos and we want to make sure that we have products that address the needs of all the constituents in that marketplace from the creative professional and high end consumers all the way to communicators at home and work. Photoshop Elements has been, for the most part, expanding our business and in fact we've been getting market shares as we said at the expense of our competitors who have been in that space.

So we look at it and we say of all the [inaudible] business our strategy is really to add value for the creative professional, continuing to see the communicators won the best and they are willing to pay for Photoshop, moving to Photoshop, and then providing line extensions. So we've talked about the management product that we'll been delivering and so that's really the strategy. But within the creative pro community and with high end consumers the still perceive added value that we give to them in Photoshop.

The casual user who tends to buy Photoshop is no different than a casual driver who wants to buy a Mercedes or BMW. They're not going to be happy with a Toyota that even though it might be as good as the Mercedes in terms of driveability.

If we look at the research on which nonprofessionals are buying Photoshop, it's clear that buying they want the best, they want the brand. It has less to do with specific features in the product. They won't be happy - it's about status and they won't be happy with the junior products and we believe that will continue to be true of those people who effectively buy Photoshop.

I don't know if you break this out, but you can help us understand how big Photoshop Elements is relative to the graphics category, and did we not have a full quarter of it in the third quarter so its impact in the fourth quarter might explain some improvement in that graphic segment, or is it just so small that it's not that important?

It's an important part of our business. It's not near Photoshop, but it's an important product. Not all the language versions shipped in the quarter. Japanese, for example, will ship in the fourth quarter. And also Photoshop Elements is a product that's target nicely in the holiday buying season, so we tend to see strength in the fourth quarter in some of our markets with the mid range digital imaging product.

Okay. Thank you.

Our next question comes from Keith Gay of Thomas Weisel Partners. Please go ahead.

Most of my questions have been answered, but on the gross margins you broke out the services line for the first time. Does that indicate that you expect that to become a larger line over time? Admittedly it's small right now and longer term, I'm looking one or two years, does that become a larger line item in there? What's the gross margin impact?

Keith, in regards to breaking it out, we think that's important, similar to what you see with other enterprise software companies, try to separate out of the service and support for the enterprise relative to product and so we started doing that this quarter. It's the first quarter we really have a full quarter with those services and support, and clearly we would like that to grow nicely for us over the next couple of years. That's very important to our overall strategy for the company. It will have a lower margin than our product margins, but again, I don't think it's going to have a major impact on the gross margin.

I think the one comment I would add to that is strategically for the [inaudible] business we continue to believe that's going to be a leverage model where we work with third parties to get the solutions out with the customers.

Okay. And then operating expenses, looks like you've got that line to about 180 million right now. We assume you will be pretty stingy with the who R and D level. I would imagine test marketing will go up on higher revenue levels. But are we - is this a level of op ex that you think you will be able to get pretty decent operating leverage off of from this level?

We're going to continue to manage expenses very tightly across the board. We will spend more money on sales and marketing as appropriate to drive our business. One of the things you've got to remember about this quarter, out incentive compensation was quite well relative to, say, last quarter, for example. And as we go out in the future we want to be in a position where our employees have an opportunity to drive incentive compensation and that would lift our overall operating expenses. But that aside, we're going to be very stingy with our spending.

Thanks.

Our next question will come from Steve Kahl with Goldman Sachs. Please go ahead.

I was wondering if you could provide some more commentary on that third-party channel that you just alluded to particularly [inaudible] document or any of the systems integrators how that's developing around your e-paper solutions and where you see that going for the next couple quarters.

Sure, so we continue to make progress against each of those partners. I think there are two levels, the first is from an ISV integration with solutions such as document and more media photographics our as well as with a SAP. It's [inaudible] a deep product and technical integration that we're working on with both of those partners.

And document certainly is offering its customers already with some success the Adobe graphics which was previously called AlterCast which two facilities that we have. The first is they are going to recommend that output from SAP go through the SAP output back that we've had with Accelio and we've been working on deeper technical integration. So both of those are going according to plan.

On the channel partners with respect to sales, again, in Jim's group in the sales we now have a modal where with Excentra [phonetic] we've been able to succeed. How we extend that to other partners is something we share with you.

Are they helping you develop more vertically specific products specifically or is it just general sales support?

BRUCE CHIZEN: This is Bruce. That's the plan. That's the plan. It's also a place we're putting a lot of effort and energy, but it's also the plan that takes a while to build. So it's one of those and one of the reasons why professional services is important, one of the reasons why it's important to have a direct sales force until you start creating demand, until you bring customers to them, it's hard for them to get excited. So today we have a relationship with Excentra [phonetic]. I think we can continue to built on that, but it's going to take a while before we develop more sophisticated relations with both Excentra and other professional services organizations.

So it's something we know is going to take time. When I look at the overall transformation for the enterprise, that's the place we have to invest. The most it's going to be the one that requires the most amount of effort on Adobe's part.

The good news is for us this is not rocket science. Developing an in market capability enterprise has been done many times by many organizations so it's something, it's a formula that's pretty easy. We have the products, you'll hear a lot more about new server products hopefully at the analyst meeting but not before then, and you'll see that we have the right solutions and then you'll see the to the market plans go along with it. But we're not as far along as we would like but quite frankly, I think people who understand that channel, if given the focus you've had, realize it takes a while to build up a core competency.

Thank you.

Our next question comes from Steve Ashley with Robert W. Baird. Please go ahead.

Were Photoshop revenues up sequentially in the month of August?

Yeah, Murray's kind of looking at me and say do we really want to answer. You know, I don't want to get into getting in minute detail on each product by month, by week. It opens up a whole bunch of issues relative to competition, relative to customer expectations, and I don't think it's in the best interests. I think, what Murray says the last couple weeks in Europe along with August in the U.S. were strong, clearly that as is across the bulk of our products.

Good enough. And does Accelio benefit at all from the fiscal year-end budget flush from the government that ends in October?

We believe so. Yes. I mean, if you look at some of the wins we talked about in the government, those are what we believe to be repeatable solutions. So, you know, one state is implementing a solution, there's no reason we can't take that to the other 49 states. Where one federal agency is implementing a solution there's no reason why we can't take that to all federal agencies.

I'll ask that a little broader. Maybe you can comment on the pipeline you're seeing at Accelio and specifically on the large deal activity that you see in the pipeline.

You see a ton of interests. We're not prepared today to talk about a pipeline in particular.

Perfect. Thanks a lot.

Our next question comes from Jay Vleeschhouwer from Merrill Lynch.

Thanks. To follow up on Accelio and a couple of other items. How much of the sequential increase in Accelio came from backlog or some kind of reinstatement of contracts that you'd had with existing customers? Back in the spring you talked about some reservations you'd had with the deals with Accelio had cut. Did you somehow improve the terms to some of those to your favor allowing you to get this better sequential revenue recognition?

Second, for Shantanu, you said the collection business was up year over year. Was that solely due to the design collection or were any of the other collections better as well?

And then finally could you update us on the Acrobat light test which you've been running in Europe.

Jay, I'll take the first one on Accelio. Yes, we did get some revenue in the third quarter that came from deals in the second quarter for a variety of reasons we chose not to complete. At the same time we saw a nice strong business in the third quarter that was new to the company, the [inaudible] overall revenue. We have worked through a lot of the issues on many of the deals and worked through some of our processes. We have not completed all of them, but we made good steady, good solid progress in the quarter.

If you look at it, Jay, going from the 1.7 to 8.8, there's a big improvement. I do realize that Q2 was a half a quarter of business, I'm sorry, 1.6, to A plus, but still, more than 100 percent increase in revenue. And as I speak to customers, I am more convinced today than ever before that this was the best decision and absolutely the best decision for Adobe. It's giving us access to customers at a level that we couldn't have access to before and will become mission critical at the enterprise level.

With respect to the other two questions, Jay. On the collections business, certainly design given it contains the flagship and design along with the other products is seeing the strongest in terms of the collection business, so that is in fact correct. We did see good business with the video collection given Premiere also shipped. With respect to the Acrobat line, we're encouraged with the results we've seen. We'll talk about that more at the analyst meeting.

Just a follow-up on PDF. I saw you briefly at Seebold [phonetic]. You made some remarks in your keynote with respect to extending PDF's technology and there was a lot of questions, technical questions about variance of PDT if like PDFX and so forth. Can you talk about the market expansion opportunities are as a result of these new variances of PDFs but on the other hand some of the technical difficulties or challenges it presents for you to develop or keep track of all these variants of PDF.

Sure. I think one of the most gratifying things about being part of the Seebold [phonetic] to just see the impact that PDF has, and I think all of us at Adobe continue to be really pleased with what we see there. I think within the creative community PDF has taken huge place in terms of digital workflow and people are seeing the benefits of moving to a digital work flow. And some of the standards you've seen involve are all around. How can people send ads in PDF and how can people print in PDF? So I think you're going to continue to see PDF take adoption their standards with respect to their ads or respect to print.

And all of those are actually minor variants of PDF where in terms of references are in the PDF file there is just a little bit more standardization. So we don't look at that as issue at all, Jay. We're happy to see that. Where we really talk about extensions to PDF is all about how do we make it more of a life document and a life container of information with the additional XML.

So within the enterprise as we look at some of the solutions that Accelio has built and we were building prior to the acquisition of Accelio that it can now really be an intelligent document within an enterprise. And so it can contain not only the presentation information but also the information about how that might be routed in the enterprise and how it can directly get information from databases.

And simultaneously I think the opportunity in the enterprises that you see government standardize on archival standard or you see government standardize on what kind of business process happens between government and consumers. We want to make sure that PDF is the standard that's adopted there. So there again, we look at it as, you know, these are minor variants of PDF to allow us to get more standardization across those work flows.

It's important to note that most of those initiatives, PDFX for the advertising industry, PDFA for a government archiving solution are bodies that we participate in. Clearly since we control the spec or the spec changes when we upgrade, Acrobat, these bodies, standard bodies work closely with us so we can incorporate their ideas and thinking into future releases of the product.

The third area I would just mention is also extending PDF to really be a nice container for digital imaging, and you've started to see us do that with Photoshop Elements 2.0. When you want to share digital images, against, PDF is a great standard to do that.

Thanks.

Our next question will come from Steve Jue with RBC Capital [inaudible]. Please go ahead, sir.

Thanks, I'm wondering if you could review the international release schedule for products next quarter in Q4 and maybe just a little more commentary on InDesign in Japan [inaudible] designer market share.

Sure. So with respect to international products, again Premiere and Photoshop Elements you will see the majority of foreign languages shipped this quarter and so that's as it relates to international versions those are the ones that I'll focus on.

With respect to Japan, again, we continue to see increase adoption in Japan. It's only - and I think people are seeing the benefits of InDesign, but that just like I think you've seen across the rest of the world, people are running [inaudible] and are evaluating InDesign.

The other challenge in Japan is the whole issue around typography and fonts. Therefore the adoption cycle is going to take a little bit longer in Japan than it will in the other market for InDesign.

Great. And just quickly on Photoshop Elements. I think I recall that was one of the leading selling markets for Photoshop Elements in the previous version; is that correct?

Yes.

Photoshop Elements J version will ship this quarter.

Operator, do we have any more questions?

Our next question comes from Bill Lennan with WR Hambrecht. Please go ahead with your question.

Hi, guys. Can you hear me?

Yes.

Just a question on Illustrator, the patterns you talked about with the Photoshop where historical upgrades are about the same but new units are slowing down, is that possibly a similar story with Illustrator?

And secondly on Illustrator and Photoshop, given that they're down over historical levels do you see release cycles for either or both products changing materially, faster or slower? Thanks.

Illustrator has been holding surprisingly well and sustaining itself. We think that has less to do with the market dynamics in terms of the whole category as opposed to significant market share gains.

If you look at the two other professional products, one truly a professional product, one with question whether it's really professional or not, we seem to be gaining market share from both. I was going to say FreeHand [phonetic]. I guess that's not true. Given Freehand and Corel Draw, we are gaining market share, and that is giving us an upkick relative to what we would expect in our illustrative revenue.

With respect to the second question, Photoshop release cycles, we haven't seen anything that would cause us to change our historical pattern of releases for both of those products.

Operator, we'll do one for question.

Ladies and gentlemen, as a reminder to register for a question press the 1, 4. There are no further questions at this time. Please continue.

This concludes our call today, and we thank you for joining us.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line.