Adobe Inc (ADBE) 2003 Q3 法說會逐字稿

Ladies and gentlemen, thank you for standing by and welcome to the Adobe Systems Q3 fiscal year 2003 earnings conference call.

During the presentation, all participants will be in the listen-only mode.

Afterwards we will conduct a question-and-answer session.

If you have a question, press the one and followed by the 4 on your telephone.

As a reminder, today's conference is being recorded, Wednesday, September 10th, 2003.

I will turn the conference over to Mr. Mike Saviage Director of Investor Relations.

Please go ahead sir.

Thank you, good afternoon thank you for joining us.

Joining us on the call today are Bruce Chizen, our President and CEO, Murray Demo, Senior Vice President and CFO, and Shantanu Narayen Executive Vice-President of Worldwide Products.

On the call we will discuss the financial results of our third quarter fiscal 2003.

By now you should have a copy of our Q3 earnings press release which crossed the wire about 45 minutes ago.

If you need a coppy 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 the information discussed in this call particularly our revenue and operating model targets for the coming quarter and forward looking product plans contain forward-looking statements that involve risk and uncertainty.

Actual result may differ materially from those set forth in such statements.

For discussion of these risks and uncertainties, you should review Adobe's SEC filings including our annual report on Form 10-K for fiscal 2002, and our quarterly reports on Form 10-Q in fiscal 2003.

During this call, we will discuss pro forma financial measures, the GAAP financial measures that correspond to such pro forma financial measures as well as the reconciliation between the two such measures are set forth in our press release issued today and are also available on our website.

Call participants are advised that the audio is being broadcast live over the internet and being recorded for playback purposes.

The audio of the call will be archived on Adobe's Investor Relations website for approximately 45 days, and is the property of Adobe systems.

It may not be rerecorded or reproduced or distributed without prior written permission with Adobe Systems.

I will turn the call over to Bruce.

Thanks Mike.

I am pleased to report our performance in Q3 exceeded the company's target ranges for revenue and earnings.

Revenue grew by 12% to $319.1 million, our fourth consecutive quarter of year over year growth.

Our success in the quarter was driven by the global performance of our ePaper business which grew 62% year over year fueled by the release of our Acrobat family of products.

The continued worldwide growth in Acrobat adoption is a result of individuals, enterprises and governments moving to electronic document work loads to gain efficiencies and to reduce cost.

We also continued to execute well against our overall business plan.

We delivered our products on schedule.

We managed our expenses effectively, and we grew net and operating income substantially on the year-over-year basis.

In addition, we had another strong quarter of cash generation.

I will turn it over to Murray for a review of our financial result and then Shantanu who will provide product related highlights.

Thanks, Bruce.

For the third quarter of fiscal 2003, Adobe achieved revenue of $319.1 million.

This compares to $284.9 million reported for the third quarter of fiscal 2002 and $320.1 million reported last quarter.

GAAP net income for the third quarter of fiscal 2003 was $64.5 million compared to $47.2 million reported in the third quarter of fiscal 2002 and $64.2 million last quarter.

Pro forma net income which excluded the amortization of good will restructuring and other charges and investment gains and losses from the company's venture program was $66.3 million compared to $52.5 million reported in the third quarter of fiscal 2002 and $66.7 million last quarter.

GAAP diluted earnings per share for the third quarter of fiscal 2003 were 27 cents based on $240.5 million weighted average shares.

This compares with GAAP diluted earnings per share of 19 cents reported in the third quarter of fiscal 2002 based on $243.4 million weighted average shares and GAAP diluted earnings per share of 27 cents reported last quarter based on $239.2 million weighted average shares.

Pro forma diluted earnings for the third quarter of fiscal 2003 which excludes an investment loss from the company's venture program and a partial reversal of a previous restructuring charge of 28 cents.

Gross margin for the quarter was 93.1%, compared to 88.9% in the third quarter of fiscal 2002 and 92.7% last quarter.

Our business is increasingly being driven by licensing revenue which is favorable to our gross margin.

GAAP operating expenses for the third quarter of fiscal 2003 were $204.8 million.

Pro forma operating expenses for the third quarter of 2003 which excludes a $439,000 reversal of a prior restructuring charge for $205.3 million.

Regular employees at the end of the third quarter totalled 3,486, versus 3,440 at the end of the second quarter of fiscal 2003.

Expenses as a percent of revenue break down as follows.

Research and development 21.6%.

Sales and marketing 33.3%.

G&A 9.5%.

Operating expenses as a percent of revenue were slightly below the target ranges provided at the outset of the quarter due to better than targeted revenue and effective operating expense management.

GAAP operating income in the third quarter of fiscal 2003 was $92.2 million or 28.9% of revenue.

This compares to GAAP operating income of $69.5 million or 24.4% of revenue in the third quarter of fiscal 2002 at $91.5 million or 28.6% of revenue last quarter.

Excluding the amortization of goodwill and restructuring and other charges, pro forma operating income in the third quarter of fiscal 2003 was $91.8 million or 28.8% of revenue.

This compares to pro forma operating income of $73 million or 25.6% of revenue in the third quarter of fiscal 2002 and $91.5 million or 28.6% of revenue last quarter.

Other income for the third quarter of fiscal 2003 was $3 million.

Adobe's effective tax rate for the third quarter of fiscal 2003 was 30%.

Compared to 32% in the third quarter of fiscal 2002 and 30% last quarter.

I will now discuss Adobe's revenue by market segment.

Creative professional segment revenue was $82 million in Q3 fiscal 2003 compared to $86.6 million in Q3 fiscal 2002 and $93.7 million last quarter.

Digital imaging and video segment revenue was $88.3 million in Q3 fiscal 2003 compared to $96 million in Q3 fiscal 2002, and $95.4 million last quarter.

Normal seasonality and product life cycle timing contributed to the expected declines in our creative professional and digital imaging and video businesses.

OEM postscript and other segment revenue was $21.8 million in Q3 fiscal 2003 compared to $23.7 million in Q3 fiscal 2002 and $23 million last quarter.

EPaper solution segment revenue was a record $127 million in Q3 fiscal 2003 compared to $78.6 million in Q3 fiscal 2002 and $108.1 million last quarter.

In Q3, with the release of the new localized version of Acrobat 6, total ePaper desktop revenue was a record $109.5 million.

EPaper server revenue in Q3 was $17.5 million, a sequential increase over the previous quarter.

Turning to revenue by geographic segment, the results in Q3 fiscal 2003 were as follows, the Americas, 49%.

Europe 26%.

Asia, 25%.

In reviewing our geographic performance in Q3, Europe and the Americas met our expectations.

In August, our North American education business was solid.

And Europe experienced the typical seasonal upswing if business in the last two weeks of the month.

Japan exceeded our expectations and appears there has been a modest improvement in business conditions.

Application platform mix was 77% Windows and 23% Mac in the third quarter of fiscal 2003 which compares to 72% Windows and 28% Mac for the third quarter of fiscal 2002 and 73% Windows and 27% Mac last quarter.

Our trade DSO in the third quarter of fiscal 2003 was 31 days.

Below our target range of 40 to 45 days.

This compares to 46 days in Q3 fiscal 2002 and 36 days last quarter.

DSO was lower this quarter primarily due to the timing of the Acrobat 6 launch earlier in the quarter.

Our global channel inventory position continues to be within company policy.

At the end of the third quarter of fiscal 2003, cash and short term investments were $852.7 million compared to $782.6 million at the end of the second quarter of fiscal 2003.

Turning to Adobe ventures, we incurred an investment loss of $3 million in Q3 fiscal 2003.

In the quarter, we made additional investments of $600,000.

In total, Adobe has invested $220.6 million through its venture partnerships and direct investments.

As of the end of the third quarter, the net returns in this program were $345.3 million including the stock dividend to stock holders and market value investments still held by Adobe.

In regard to share buyback, Adobe repurchased approximately 1.2 million shares at a cost of $39.2 million during the quarter as part of its on going share repurchase program to offset delusion from employee stock programs.

Adobe's board of directors declared this quarter's cash dividend of 1 1/4 cents per share payable on October 7th, 2003 to stock holders of record as of September 23rd, 2003.

This includes my discussion on third quarter fiscal 2003 results.

I would like to discuss our Q4 fiscal 2003 targets.

We are targeting revenue of $330 to $350 million.

As a percent of revenue, our approximate operating model targets for the quarter are as follows, gross margin 93%.

R&D 20% to 21%.

Sales and marketing 32%.

G&A 9%.

Resulting in a GAAP and pro forma operating margin target of approximately 31% to 32%.

For our share count, we are targeting a range of 243 to 245 million shares.

For other income, we are targeting approximately $3 million and for our tax rate we are targeting 30%.

These targets lead to a GAAP and pro forma earnings per share target range and Q4 fiscal 2003 of 30 to 32 cents per share.

We currently believe that targeted pro forma earnings per share and pro forma operating margin results will not differ materially from targeted GAAP results.

This concludes my comments.

I will turn the call over to Shantanu Narayen.

I will spend the next few minute reviewing Q3 highlights in each of our major business segments starting with ePaper.

As Bruce mentioned earlier, continued strong adoption of Acrobat led to another record quarter for ePaper revenue.

As you may recall, we first shipped the English version at the end of Q2.

During the early part of Q3, we began shipping other major languages including German, French and Japanese.

Through the end of the quarter, we continued to see strong global demand for the desktop products.

Early results from the Acrobat 6 release indicate the following, adoption of the professional version has been significantly stronger than expected.

Upgrades as a percentage of the installed base for Acrobat 6 are slightly higher than Acrobat 5.

Licensing business has been strong.

In Q3, as a percent of total ePaper desktop revenue, licensing was 38.7%.

Acrobat elements particularly versions 6 which was just released, is contributing a relatively low percentage of the overall ePaper desktop revenue.

Reviews and awards for the Acrobat 6 family of products have been outstanding.

C-net gave Acrobat its Editor's Choice Award and stated "Adobe Acrobat 6 is one of those rare programs that includes something for nearly everyone.

All users will appreciate the capability to create PDF documents simply by clicking a button in most Office applications.

And Acrobat offers excellent new work flow and commenting tools".

Our Q3 ePaper success also extends to our server base business where we once again had sequential revenue growth.

Driving this performance were a number of significant deals across many verticals around the world.

In the government market, they include the FAA which is modernizing its website to provide the capability for external customers and employees through transact business with the FAA electronically.

This effort will help the agency comply with the Government Paperwork Elimination Act.

The employment standards administration within the U.S.

Department of Labor is enabling the public to electronically submit PDF based forms with the Adobe Reader by deploying Adobe document server for reader extensions.

Their goal is to be complying with the Government Paper Elimination Act by making E forms available to the public which allow for electronic signatures and electronic form submission using the Adobe Reader.

Orange County, California, the fifth largest county in the United States has standardized on Adobe's E form and out put solutions for all of its departments internal and external facing electronic form application.

In Australia, the [INAUDIBLE] Aviation Safety Authority is implementing Adobe E form server products to provide links between people,aircraft, and organizations within the Australian Aviation Industry.

The project is an implementation in conjunction with Siebel, Documetum, and Business Objects.

In Germany, the German Federal Finance Office is using E forms created by Adobe document server for reader extensions to allow its clients the ability to edit, save and sign PDF forms with the free Adobe Reader.

And in the Netherlands, the ministry of OCNW responsible for education, culture and science and the largest federal government ministry in the Netherlands is implementing a solution where applicants can download application forms directly from their website in PDF and return them electronically.

In the enterprise market, [INAUDIBLE] with our server solutions included, Prudential Real Estate and Relocation, a subsidiary of Prudential has licensed Adobe E form Solutions to enable their corporate clients to access and submit relocation forms electronically.

British Airways PLC is licensing form server and work flow server to provide British Airway staff with an electronic work flow system for every day forms.

Toyota PLC working with their systems integrator Connect i, is using Adobe document server to enable Toyota's network of dealers to customize branded marketing communication materials quickly and easily.

Deutsch Post AG, one of the largest European providers of mail express and logistic services has licensed additional Adobe E form client software to extend their electronic handling of at the counter business transactions allowing access to approximately 150 electronic forms.

And in Spain, [REPSAL YPF] an international fortune 500 company and the leading worldwide company in petteral chemicals is implementing a project to automate engineering and documentation and electronic invoicing using Adobe Document Server and Document Server for reader extensions.

In our overall ePaper business, the average of the top ten transactions in the third quarter was $466,000.

The average was higher due to two transactions.

Backing those deals out, the average of the top ten transactions was consistent with the past several quarters.

Our success with our ePaper business both server and desktop, is built on the ubiquitous Adobe Reader and Adobe PDF as a dynamic cross platform format.

Info World recently stated, "Adobe PDF has become the gold standard for electronic documents".

Turning to our digital imaging and digital video business, we delivered a comprehensive line of professional video and rich media creation products.

Premier Pro, After Effects, Edition and Encore DVD give Adobe a leading video offering platform to target the growing professional digital video software market.

All of the new products have received great reviews.

For example, with Premier Pro, both magazines stated "It is making the industry do a double take."

Digital Media Net said, "The best news is the age old editor managed to retain just about everything you might have liked about it while adding so many pro level enhancements."

And Digital Video Editing dot-com stated, "Adobe's new editing applications leaves others in the dust."

The new video product line and video collections shipped in the English late in Q3 localized versions will ship in Q4.

In regard to Q3 results in our digital imaging business, it's anticipated we saw a year over year decline in our Photo Shop business due to compared with last year when Photo Shop 7 was early in its product cycle.

Sequentially, Photo Shop revenue declined modestly which was expected given summer seasonality.

Our digital imaging consumer and hobiest revenue grew on a year-over-year basis.

On a worldwide basis, we gained market share for Photo Shop Album and Photo Shop Elements.

This strong market position will benefit us as we move in to the holiday buying season.

Turning to our creative professional business, InDesign continued to perform well.

Combined revenue from InDesign and Design Collection grew 19% on a year-over-year basis.

We continue to see major customers and service providers adopting in design.

For instance, Guardian Newspapers one of the world's largest installation of Quark QPS is switching users to InDesign and InCopy.

And AGT 7 a division of Applied Graphics Technologies and provider of graphic services to the advertising community has expanded its support for InDesign.

AGT 7 the world's largest print service provider is also providing training to move its customers to InDesign.

These customer and infrastructure successes are important as our competitor reviews of InDesign versus Quark Express.

Mac Addict stated, "Our experts put Quark Express 6 through its paces and they aren't impressed.

In a head to head feature comparison, InDesign beats the pants on Quark 6 and the gap will undoubtedly widen when InDesign 3 is released."

Looking ahead, we plan to release several major products in the fourth quarter and we will be hosting a launch event in New York City on September 29th.

This concludes my Q3 business segment review.

Bruce.

Thank you Shantanu.

Our results in Q3 and over the first nine months of our fiscal year demonstrate solid execution.

Our achievements to date have been substantial and include the following highlights.

We've met or exceeded our financial targets.

We've delivered the most comprehensive product family in Adobe's history with the launch of Acrobat 6.

Which has resulted in consecutive quarters of record ePaper revenue.

We're building on our ePaper desktop success with the delivery of mission critical server base solutions for the enterprise customer.

And we have delivered a new high performance integrated product line for video professionals to lead the video desktop publishing revolution.

Looking to Q4, we're excited about several upcoming major product releases that will serve the needs of our customers.

Helping to drive our target of another quarter of double digit top line growth.

The foundation we have built makes us optimistic about our growth opportunities in 2004 and beyond.

We were looking forward to sharing more with you at our financial analyst meeting in October.

Mike?

Thank you Bruce.

Before we start Q&A, I would like to review some important calendar dates.

Customer event on September 29th will include presentations by Adobe's executive team.

We plan to simultaneously webcast audio and slides of the key note presentation from Adobe.com.

Details and webcast access information will be announced in a press release prior to the event.

As a reminder, our annual financial analyst meeting will be held in New York City on Monday October 27th.

Invitations for the meeting will be sent out in a few weeks and we will simultaneously webcast the meeting.

We plan to release our regular interquarter update for the fourth quarter of fiscal 2003 on the day of our analyst meeting, October 27th.

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 21158466.

Again the phone number 402-977-9140.

With reservation number 21158466.

The phone playbook service will be available beginning at 4:00 P.M.

Pacific time today.

And ending at 4:00 P.M.

Pacific time on Friday September 12th, 2003.

We now will be able to take your questions.

Operator?

Thank you.

Ladies and gentlemen, if you would like to register a question, please press the 1 followed by the 4 on your telephone.

You will hear a three tone prompt to acknowledge your request.

Your question has been answered and you would like to withdrawal your registration please press the 1 followed by the 3.

If you are using a speaker phone please lift the handset before entering your request.

One moment please for our first question.

Our first question comes from Ben Reitzes with UBS.

Please proceed with your question.

Nice quarter, guys.

Thanks.

Wanted to ask a couple of things.

When I look at the performance, Japan was strong and ePaper were strong.

At least stronger than I had thought.

Is this -- how would you characterize this that the quarter was carried by Acrobat and the economy is the same, better or worse?

How would you characterize it vis-a-vis the economy and where we are going given that Acrobat was so strong and Japan, how do we look at that?

Ben, the way we are viewing the economic conditions around the world in which we participate, Japan we did see a modest improvement and we believe that as we move into Q4 that that would be what we would continue to experience into Q4 and then into '04.

When we look at the U.S. or North America and Europe, we see the economy is relatively stable.

We have not seen any significant improvement or in fact we haven't seen any improvement at all other than the Acrobat increase we believe that the market stable hasn't gotten any worse hasn't gotten any better.

That's U.S. and Europe?

That's U.S. and Europe.

With regard to Apple and some of the new products there, have any of those helped or do you expect is any a boost because of some of the things they are doing included in your outlook for next quarter?

This is Shantanu Narayen.

I think the G-5 is a great machine and overall should help the adoption of OS 10.

We are not really factoring it as a key driver into our target.

And as you know, we continue to take support and advantage of G-5 in key applications like Photo Shop.

I think we are ready as the platform extends to make sure we take full advantage of it.

Is there at least a high attach rate when they ship the G-5?

What kind of attach rate do you see?

It's way too early.

I believe their initial shipments went into the education market.

Our education business was relatively solid in North America and the quarter.

But we haven't yet been able to determine the impact of the G-5 and Adobe's business.

We are excited by it.

If those creative professional customers move quickly on the G-5 and they will move over time, but if they move quickly, it will mean they will need to move to OS 10 and that will clearly benefit Adobe and its business.

It's still to early to tell how quickly that is going to happen.

Lastly, and I don't know if you are going to answer this.

Conference call on the 29th sounds important.

Does this mean that Photo Shop is included in the illustrator InDesign launch?

How are we supposed to read that?

First of all I want to apologize for creating a little bit of fuzziness around the product announcements.

We try to every quarter give you some indication of what's going to ship within the quarter.

The concern we had is depending when we announce the product we could potentially lose sales of existing products and we didn't want to run the risk.

We didn't think that was in the best interest of our shareholders and overall business.

It will become much clearer on the 29th.

It is a major event for us.

Shantanu Narayen and I will be giving presentations to our customers and webcast will be made available simultaneous webcast will be made available to financial community.

So I ask you to bear with us for another couple of weeks and everything will become much clearer on the 29th regarding products that will be releasing over the next quarter are significant.

Thanks.

Take care.

Thanks, Ben.

The next question will come from the line of Jay Vleeschhouwer with Merrill Lynch.

Bruce I would like to ask you about the volume licensing portion of the Acrobat business.

So it looks like you had about a $20 million sequential increase in volume licensing for Acrobat, about the largest increase I think that we have seen.

The question is what does the pipeline look like for continued further sequential or absolute increases in volume licensing?

Shantanu mentioned that element is still relatively small so presumably it was standard or perhaps more pro that drove that business.

What are you seeing for continued further growth in terms of the volume business.

And then secondly, referring back to a comment Shantanu made on the last call with regard to your bundling and technology strategy, you made comments the last time about work flow and product integration and that had some implications I believe for pricing and packaging of bundles and product.

If you could perhaps elaborate on that.

I will take the first part of that question.

In terms of the volume licensing business, we had a great quarter in Q3.

And overtime we continue to believe that we can continue to gain in the area of volume licensing as we continue to proliferate Acrobat and PDF within enterprises.

Our overall view though with where we stand with ePaper revenue for the fourth quarter, what we are factoring in is that we expect to see a tail, slow down in the upgrade revenue aspect of the ePaper desktop business that will lead to a sequential decline for our ePaper business between Q3 and Q4.

So over time we continue to believe that licensing is going to be successful for us.

But in the short term we are looking for the upgrade revenue to decline from Q3 to Q4 which will lead to an overall decline in the ePaper segment from Q3 to Q4.

After that we were focused on trying to drive for the greater opportunity that we believe we have and the ePaper arena.

And we anticipate that the server business will be once again up sequentially.

So with respect to the second question, as it relates to work flow and product integration for the bundles, the creative pro customer we continue to be focused on three things.

The first is continuing to deliver best of breed applications.

The second is to insure that all of our products work well together and seamlessly in the collections that we deliver, the design collection, video collection, et cetera.

And third is as we extend that from being just from the desktop and work groups, to ensure that they seamlessly with each other that is the driver of our product strategy and I think as you see us ship our products, with all of them we will add best of breed capability features and integration features to enable these work flows.

Should we expect with the next releases of let's say Illustrator and InDesign and whenever Photo Shop happens to go that you will raise the prices of the stand alone product, leave bundle prices alone and there by improve the value attractiveness of the bundles relative to the stand alone products?

I think at this point point we aren't making any announcements on pricing.

I think again collections is our focuses how do we continue to provide value to the creative pro customer.

Thank you.

The next question will come from the line of Gene Munster with Piper Jaffray.

Please proceed with your question.

Gene Munster, your line is now open for the question.

Can you hear me?

Yes.

Great.

In terms of the product time.

And Bruce, hypothetically, if Photo Shop came in the November quarter, what impact would that have on operating margins, if you can address that.

Are you going to manage to an operating margin or let it flow through?

This is Murray.

We provided our targets for the fourth quarter of 330 to 350 in revenue and operating margin targets of 31% to 32%.

So we are looking for operating margin improvement over what we see in the first three quarters in the fourth quarter.

But in terms of being specific around products, we aren't commenting on that today.

Okay.

How about this, just in terms of as you [INAUDIBLE] And we adjust our miles or do whatever we need to do around the 29th, [INAUDIBLE] Operating margin or is it -- I think historically you have talked about managing certain operating margin levels.

Is that going to be the strategy going forward I guess independent of any sort of time of the product cycles.

In terms of the targets we provided today, they factor in what we are going to communicate on September 29th.

We factored all that in to the targets we provided.

We will provide more specific information on products on that day.

The targets financially for this quarter are tied to what we will say on 9-29.

In terms of just the enterprise side [INAUDIBLE]

Gene, you breaking up with your call.

Okay, just in terms of the target and terms of kind of the enterprise Acrobat side, can you give an update in terms of how many direct sales people are on that and what your goals are there and how that is tracking?

What we said at the beginning of the year was we want to have approximately 60% of our field organization which includes our sales organization and the field marketing organization.

So the organization that touches the customer to be focused on the ePaper opportunity and that includes both Acrobat and the ePaper service, we have reached that milestone and we now have more than 60% of our sales organization.

We don't focus on those opportunities.

We don't break out of the quantity of people that is nor do we communicate which of them are exclusive to Acrobat or exclusive to the server products.

Many of them are responsible for marketing and selling both products because the customers are one in the same.

I will point out that the desktop licensing of revenue of 38.7% of the total along with the sequential revenue increase of the server business is an indication of some of the success that we are having against that overall enterprise effort.

And just lastly in terms of the consumer side, general thoughts on Photo Shop elements and how the consumer market is reacting.

I know it's just a fractional part of your business.

Any thoughts on that front?

With respect to consumers and hobbies as they move, we continue to see adoption of software as this whole move toward digital photography happens.

From our perspective what we have been focused on is continuing to have absolutely best of breed applications so we look at it from is our brand out there?

Are we making sure we get the reviews and influences and are we gaining market share?

In addition to making sure that we have the retail presences.

As they want to buy software, we are the first choice.

We continue to think that the trend there is digital cameras and people using computers to deal with it.

We think it's going to continue.

But in terms of I would say quarter to quarter your growth rate and expectations with the consumer, are there any changes on that front?

We continue to think it will grow.

And there is a seasonality aspect of it, Gene, on the -- especially if you look at consumer behavior.

Q4 and Q1 tend to be the strongest quarter for software purchases at the consumer realm.

We are expecting that the market share gains that we are experiencing in Q3 will result from a sequential basis significant revenue increases into Q4.

For those consumer oriented products like Elements and Album.

One more final question and revisiting my initial question, I know that you set your guidance and talked about the operating margin would look like.

If for example there was upside to the revenue, how would that flow through -- I don't want to create a whisper case here.

But we talk about several products and there could be significant products which could be set up for a pretty strong November quarter.

If there was upside on the revenue side, would you manage that operating margin on a revenue upside or would you let that flow through.

I know you've answered that, but one more try at this.

So in terms of the again the revenue targets of 330 and 350 factor in what we are going to say on 9-29.

What we have is a couple of things.

Clearly we have a leverage model.

What you have seen in other quarters where we have exceeded on the revenue side, we have seen an improvement in our operating margin because more than half of our expenses are tied to people.

We will need to focus on if there was a situation where the revenue came in higher and that was going to drive the margin we will always make a decision between should we take advantage of that and invest for revenue in future quarters or should we let it go to the bottom line.

That's something we would decide during the quarter around that.

Again, the leverage model is in place but we want to make sure to make the right decision for both the short term and long term in terms of profit growth.

Great, thanks, guys.

Next question will come from line of Steve Ashley with Robert W. Baird.

Proceed with your question.

Mike congratulations on the quarter.

Can we talk about elements a little bit.

You mentioned it's just a small fraction of the total revenue.

Is it unfolding as you expected or maybe you can talk about sales cycles and what you are seeing there.

This is Shantanu.

Setting the overall context, we are pleased with the Acrobat desktop performance.

Reviews have been outstanding.

The various features and the targeting and segmenting of the product seems to be resonating with our customers.

What we have seen so far is while it's early in the product cycle, Acrobat Pro revenue has been higher than expected and we think this is because of the specific features that we put in whether it's the creative pro market or the engineering market, I think equally if not more important the focus that we have as an organization in driving our sales and marketing focused on these higher revenue generating products.

With respect to Acrobat standard, it's still the majority of the revenue that we see.

And our feeling is that's because of the large available market that's available for the horizontal feature that we target with respect to secure document sharing and collaboration.

So Acrobat elements, it's a low part of the overall mix but remember, the strategy is to draw a PDF proliferation and adoption within the enterprise and make sure there is increased adoption from individuals to line of businesses to entire enterprises and we look at the availability of this entire product line as well as the licensing wins that we are getting with 38.7, as validation of success to broaden PDF acceptance within the enterprise.

It will always be one of these things where we educate people on the benefits of PDF.

Once they see the benefits of PDF they move up to collaboration and they move up to forms.

It's unfolding the way we expect it.

The customer is choosing to spend a little bit more money to go with a product with more functionality.

That's something that we are not necessarily upset about.

Great.

And you talked about two large deals in the server side Acrobat business.

Could you give us a little more color on the size and nature of those transactions.

What we want to do is at the analyst meeting is take you through a lot more details on traction against the overall server business, what people are doing to deploy a solution.

What some of the ASPs have been and what we experienced and more importantly what we can expect into the future.

I think it's clear from the handful of customers that we listed this afternoon that customers do see the value proposition but to go into the specific details at least at this time, I would rather wait to go into more detail at the analyst meeting.

Lastly, maybe a quick comment on the video collection and if that is selling as you expected.

It's early I think in the video collection.

We got the product out in English late in Q3.

The reviews have been great.

We will have more to say later.

Thank you.

Thanks, Steve.

Our next question will come from the line of Steve Jue RBC Capital Markets.

Please proceed with your question.

Let me echo my congratulations as well.

Looking at the upcoming product cycle you talked about sinking up the release dates and pushing the bundling strategy more.

Looking out just at a higher level looking at future upgrades going forward, do you expect more lumpiness in your business as you bundle these suites and sync up some the timing of the releases?

That is one possibility, but again I think at this point we would like to be able to communicate on 9/29 what we are doing and then have more discussion around some of the financial dynamics that would go with some discussion that we would have on 9/29 and that's where we were right now.

Okay.

Great.

And then with the enterprise sales force you talked about reaching your targets in terms of shifting the resources over there.

What is your initial take in terms of productivity and pipeline building relative to your expectations at this point in time.

Overall I think we were pleased with customer references we are getting.

We are getting large transactions as well as the sequential increase in revenue for the servers.

Expectations have always been '03 as a building year and the product, the message, the channels just laying the foundation has been our focus.

The pipeline continues to build and so we are pleased.

We continue to believe that the server business for Adobe represents the largest opportunity.

It's a multiple year effort.

We are pleased that we are getting the sequential growth even during these tough times and we are expecting that will continue to see sequential growth as we move not only into Q4, but as we move into fiscal year 2004.

Great, thanks.

Murray, lastly, cost of product revenue was down just a little bit this quarter.

Was mostly driven by more enterprise licensing business or any change in how you were packaging or delivering product.

It's primarily driven by the fact that we were seeing more and more of our business move to licensing.

Obviously we are constantly looking for ways to cut costs but we can't on that direct cost line and that continues on but it's being driven by the fact that we are selling more and more licensed software as opposed to packaged shrink wrap software.

Next question will come from the line of Steven Frankel with Adam Harkness.

Murray could you remind me what the percentage in ePaper volume licensing was in Q2 and what is is a typical size of ePaper deal?

You stated the number was thrown off by two large deals.

What's a normalized number.

Last quarter we had 31.8% this is a desktop licensing revenue with the percentage of the total desktop revenue.

So again 31.8%.

Shantanu Narayen, if you want to comment on the server side.

On the server transactions, what we have for the last couple of quarters, this quarter was 466,000.

The last quarter was 293,000.

The quarter before that was 254,000.

And I was trying to give a little color as to the two large transactions.

If you will remove those.

It's in line with what we have been seeing during the past few quarters.

Shantanu on the Acrobat elements, I realize it's a good thing for people going for pro and standard, are you satisfied with the corporate evaluations that are going on that might get you to broader penetration next year based on elements?

Or do you need to work on educating the customer to take a closer look at elements?

I think we continue to focus on insuring that the value proposition of PDF generation and sharing information is well understood by customers and we continue to see a lot of success in people adopting PDF within departments and then extending that into the entire enterprise.

I think the licensing business is a reflection again of customers commitment to Acrobat PDF as a platform.

We will continue to work on it.

It's still early.

Thank you.

Next question will come from line of Keith Gay with Thomas Weisel Partners.

Please proceed.

Now that the enterprise number is getting to be fairly decent size with server and Acrobat it looks like $60 million.

Talk about the pipeline.

What do you think of in terms of going into the next quarter.

Are you using some sort of a pipeline coverage ratio?

How -- what sort of rigger do you have in the process that you can predict that number?

We look at it two different ways.

For the server business, we have a very rigorous pipeline process and we look at the stage of the deal or the opportunity and we look at the 7 different stages that we work through and we measure it over time and we expect a certain ratio for next quarter versus the ratio for four quarters out.

So very rigorous process.

Clearly we are still learning, how to make it a more predictable tool but we continue to get better and better at it.

On the Acrobat licensing side, that continues to be much more driven while there is a pipeline process.

Clearly much less rigorous on an outport because we understand the market much better.

It's much easier to understand the opportunity, the customers.

It's a desktop sale and that's something we intuitively understand.

The place where we are focused the most in terms of pipeline coverage is on the server side of business.

Which last quarter was about 17 1/2 million.

Again, we expect sequential growth next quarter.

So hopefully that answered your question.

Server growing on a sequential basis if we look out on a year-over-year basis or the run rate that you had when you bought [EXCELIO], are you pleased with that?

Is $17.5 million meeting your expectations compared to where that business was as you acquired it and then converted it over to your own products?

Compared to where [EXCELIO] was we are extremely pleased.

You have to go back and look at [EXCELIO] was a company that was struggling.

That was evident by the fact that their market cap was below their one-year revenue.

You have to look at the fact that they were in a hostile takeover position.

They didn't have the leverage that Adobe had with the ubiquitous free Acrobat reader they didn't have the ability to leverage a standard like PDF.

If you look at where we are, versus where [EXCELIO] was we have made major, major milestones.

Are we happy with 17 1/2 million?

I'm never happy with status quo and I don't think any of the team is happy with status quo.

We were talking about this being Adobe's largest opportunity across our business.

It's just one of what's realistic expectation in a sequential growth that we are showing we think is realistic.

As we move into '04 we will continue to see more of that.

I think you want to look at more importantly the quality of some of the deals that we have within talking about.

The deals that Shantanu listed in his prepared comments, how organizations whether it's a government agency or a financial institution is using our products and technology.

They are using it in such a way where it's evident it's unique to Adobe.

There is no one else that can take advantage of the free Adobe reader the way we were and those are the types of applications that they are deploying and that's what gets us excited.

Finally, who are your most important partners right now on the enterprise side?

If you look at our partners on the enterprise side, definitely the ISP partners as well as the IS partners.

Documenting is a partner we have been working very closely with.

Both with respect to Acrobat and having it archived in the content management as a front end to their content management to our forms technology.

I think SAP we continue to make good progress on making sure we can take the safety offering and extent that outside of firewall and get our forms and print technology with them.

We announced things with IBM relative to integrating again our forms technology with content manager.

Continue to make progress in that.

On the systems integrator front, we are getting a lot of wins in conjunction with these partners so we continue to work with as you can imagine the EDS's the IBM global services and extensions.

Next question will come from the line of Craig Ellis with Smith Barney.

Please proceed.

A question for you, Bruce.

Clarifying your response earlier for what you are seeing in terms of demand out there.

Are you seeing any signs as you talk to people that are considering new business that prepurchase activity is picking up given the possible economic signals we have seen in the U.S. recently?

I'm sensing cautious optimism from the other CEOs that I speak with.

At the same time, I don't see anybody willing to aggressively invest ahead of their own revenues.

And I believe it's that phenomena that is keeping the economy somewhat stable but not improving.

I think -- my opinion and certainly you on the telephone have a better sense and have people much more educated on overall economic dynamics than I am.

But my view is that until we see continued improvement more consumer confidence, a great holiday buying season, we probably won't see significant confidence in corporations willing to spend ahead of their revenues.

So not a head wind but not a tail wind yet.

That would be a correct assessment.

Murray, for you, just understanding the expense profile, I know there were some special product launch expenses for the quarter.

Clearly there will be some in the fourth quarter that's in the guidance.

Sounds like overall we are 60% of the staffing and direct sales force.

How should we look at expenses as we go forward.

It looks like they are increasing at a rate of 2/3 from the top of the line.

Is that a good way to look at them?

Couple things, I think what Bruce is referring to earlier on the 60% was the target of getting to a 60% of our sales organization, our field organization folks on the ePaper enterprise.

We have made a lot of progress getting to that number.

So in terms of here forward, there will be a lot less of that than in the past.

We have made a lot of progress in getting there.

In terms of looking at the expenses from Q3 to Q4, including going to have a number of launch activities in the fourth quarter and was going to be a number of marketing activities will go with it that's going to increase our expenses from Q3 to Q4.

Also in Q3, we get the benefit of some vacation savings because when employees go on vacation of the third quarter, that's better for the expenses.

We won't get that in the fourth quarter.

That is what we will see any other year without a shut down and we will continue to other activities that are important to the company in terms of 2003 and beyond.

We will see an absolute increase of expenses from Q3 and Q4 for these three reasons.

Yeah and as a reminder, even with those expenses in Q4, we were talking about operating margins between 31 and 32% which we think is admirable.

Certainly.

And then just lastly, taking a look at what you are seeing from a currency standpoint, it's very minor for you, but was that a help at all and how do you look at that going into the fourth quarter?

If you look at the Euro over the past year, it has strengthened.

We did have some benefit of that in the quarter.

As far as going from this point forward, we aren't trying to make calls on where the currency will go.

We want to stay focused on our own business.

We will use short term hedging programs to protect us in the short term.

But in terms of where it's going from here, that's a tough calls.

Murray in the third quarter, was it a head wind at all?

Did it help a little bit?

Between the second and third quarter on currency?

Yeah.

It's negligible.

Thanks.

Thanks.

Next question will come from line of Sterling Auty with JP Morgan.

Please proceed with your question.

Murray, you mentioned the better margins on the license part of the business.

Can you give us a sense how much better is the economics on licensing versus the shrink wrap and how high a percentage of the desktop Acrobat could the licensing percentage get?

In terms of the economics on it, clearly shrink wrap box you've got a number of components that goes into that box that cost money.

When you get into the licensing mode where they are replicating that software from seat to seat, there is no shrink wrap cost, no user guide.

No CDs.

Et cetera and all of the other packaging materials that go into that box.

You don't have them for each additional copy.

The incremental margin licensing is significant.

We still might have royalty costs that we licensed technology from third party providers that we will still have to recognize as expense and each one of those additional units.

In terms of the material costs we wouldn't have those.

Licensing is really good for us from a gross margin standpoint.

In terms of where to go from here, clearly we think there is an opportunity to grow that licensing business and in the ePaper space and the trend in the software industry is to move to more and more licensing and move away from shrink wrap.

We don't have any specific targets today but we would like to think over time we can continue through our own efforts and also industry trends to see the overall licensing business improved for Adobe.

And obviously it was a great ePaper quarter.

Did you get the sense that there was any customer confusion over the fact there was three versions of Acrobat out there?

Are there customers that took longer to make decisions and maybe that helps the upgrade or the product cycle be a little longer than the last time out there?

Our sense is that people have benefited from having the product range and the targeted features and are actually appreciating the messaging associated with each of the products.

We continue to see that as a positive.

It is unknown and we really won't know until we move through Q4 is how much of the European business we were able to communicate with effectively.

Keep in mind, we didn't ship the foreign versions of the product or the European versions of the product other than international English until the beginning of Q3 which is right in the beginning of summer.

We don't know yet what the true results will be of Europe other than what we have already experienced in Q3.

And you mentioned that Pro was a little bit better than expected.

There is any sense as to by platform was Pro more adopted on the Mac platform versus the Windows platform?

No, I think the Pro product, people who are familiar with Acrobat understand the features and see the benefits of the Pro product and that's across platforms at this point.

Probably the most important thing to point out is that we do expect the upgrade revenue to decline sequentially.

On a year-over-year basis the Acrobat business we expect it to be up in total.

So it's going to be interesting to see how it plays out based on what we know so far that's our expectation.

Okay.

Last question is you mentioned that licensing is a trend in the industry.

Can you talk a little bit about you guys I think are looking at product activation security features in to it went down that road.

Any comment on the strategy there and what has happened so far?

I think we are looking at test of this point going relative to product activation in our products.

And beyond that at this point, we aren't going to make any announcements on with a we do with activation.

Privacy is an issue for Adobe as it is for every other software company and we continue to test different methods.

What we don't want to do is do what some of the others have done is alienate their customers in the process.

Right.

And then just let me throw one more out there.

You have a number of upgrades coming here in the fourth quarter.

From a high macro level, what drives growth into fiscal '04 for you guys?

Are there more product upgrades that we don't see coming and if you don't want to comment what else drives growth as we get into '04?

What we would rather do now is there are a couple of events coming up.

September 29th we will provide more clarity about what we are doing around this quarter and then at the analyst meeting we will go into much more detail in what we are doing fiscal year '04 and beyond.

I think what's important to note is we have been working very hard over the last number of years in building a foundation.

If you look at what we have done with the whole ePaper business and the work we have been doing against the server business, it's been significant and we were gaining traction.

If you look at the new releases of the video product, the first time that we have a truly integrated offering that is being perceived as a professional product.

And then if you look at the line extensions you have done in the digital imaging space, it's pretty significant with Photo Shop Elements and Photo Shop Album and the efforts that we have made with InDesign over Quark over the last couple of years and getting the ecosystem built around and design it's been significant.

We believe that the platforms that I just talked about will allow us to have growth in 04' and beyond.

Which leads us to a lot of optimism.

Great, thank you.

Thanks.

Next question will come from the line of Bill Lennan with WR Hambrecht.

Please proceed.

Bruce, you talked earlier about recovery whether or not you hear it in the voices of customers and their willingness to commit expenditure based on their own revenues.

I guess following up on that question, have you internally thought about what do you think the leading indicators will be for you guys on a product basis to let us know the world is getting better.

For example let's think of it in three distinct categories, sort of the Photo Shop illustrator group of products, enterprise and consumer products.

Do you think there will be some particular pocket of strength that will emerge first if and when the world gets better next year.

Clearly the creative professional market is dependent on how much money corporations and institutions spend on marketing their products and services.

So once companies believe that there is revenue to be had, they will start increasing their overall marketing spend.

And once they increase their marketing spend, more brochures will have to be created.

More advertising is designed.

More TV commercials are produced.

And other types of marketing and communications occur and that means our customers will once again have a lot of work to do and they will be out buying our products.

Creative professional is pretty clear is dependent on marketing spend which is more correlated to GDP growth than the other data point.

Regarding the consumer market, really has to do with consumer behaviors.

Consumers are spending a lot of money on incremental activities like digital photography then we will benefit.

And the enterprise, it's a little bit different.

Because even though the overall IT spend hasn't increased significantly, it's been flat, the overall amount of money that's being spent on software is still significant.

And we think that given our piece is still relatively small today that we could get a bigger piece of the overall spend today because we can help them reduce their cost and be much more efficient by taking their documents and integrating them into their enterprise systems.

Thanks for that.

One more on the licensing.

It's been asked before and I will try it from a different angle.

Can you help us understand the licensing number was phenomenally strong.

And I would have felt the kind of went -- it would have been a little bit stronger in Q3 and Q4.

I guess split more evenly.

Was there a time lag in the U.S. or North American market.

Someone mentioned educating customers and that's what I heard through the channel.

I guess the short version of the question is, why was licensing so much stronger sequentially than the shrink wrap factoring in the fact that licensing was going to steal share from shrink wrap.

Even so it just seemed really out of proportion and a very positive result for you.

Well, there is a couple of things.

If you look at what we had in the previous quarter, so Q2 was 31.8 .

Then up to 38.7.

Actually, in Q1, it was 36.7.

So it was 36.7 in Q1 and then went down to 31.8 and up to 38.7.

What was driving the increase was the fact that in Q2 the initial launch of the English versions which was a lot of shrink wrap revenue it caused be a overall mix that pushed the percentage for licensing down.

Now that we moved into the next quarter we were seeing more licensing and less of the shrink wrap.

Okay.

And finally, I think this will be the fifth question on product release timing.

I understand you don't want to say a lot about it I will just give it one more try.

Is it safe to assume you will keep some power drive for Q1 either with products that just won't come out in Q4 and are due or maybe some late releases in Q4 that will spill over?

We will have growth in '04.

Or we expect growth in '04.

In terms of which products, which releases will drive that growth, that's something that we are not prepared to go into today.

Okay.

Look forward to the meeting in September.

Thanks a lot for the long call today.

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