Adobe Inc (ADBE) 2006 Q3 法說會逐字稿

At this time I would like to welcome everyone to the Adobe Systems Q3 fiscal year 2006 earnings conference call. [OPERATOR INSTRUCTIONS]

Thank you.

I will now turn the conference over to Mr. Mike Saviage, Vice President of Investor Relations at Adobe Systems.

Please go ahead, sir.

Good afternoon and thank you for joining us today.

Joining me on the call are Bruce Chizen our CEO, Shantanu Narayen, President and COO; and Randy Furr, Executive Vice President and CFO.

On the call today we'll discuss Adobe's third quarter fiscal 2006 financial results.

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

If you need a copy of this press release, you can go to Adobe.com under the Company and press links to find an electronic copy.

Before we get started, I want to emphasize that some of the information discussed in this call, particularly our revenue and operating model targets and our forward-looking product plans is based on information as of today, September 14, 2006, and contains forward-looking statements that involve risks and uncertainty.

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

For a discussion of these risks and uncertainties, you should review Adobe's SEC filings, including our Annual Report on Form 10-K for fiscal 2005 and our quarterly reports on Form 10-Q in fiscal 2006.

During this call, we will discuss non-GAAP financial measures.

The GAAP financial measures that correspond to non-GAAP financial measures as well as the reconciliation between the two are set forth in our press release issued today and are available on our website.

Call participants are advised that the audio of this conference call is being broadcast live over the Internet and is also being recorded for play back purposes.

An archive of the call will be made available in Breeze on Adobe's Investor Relations website for approximately 45 days and is the property of Adobe Systems.

The audio and archive may not be rerecorded or otherwise reproduced or distributed without prior written permission from Adobe Systems.

I would now like to turn the call over to Bruce.

Thanks, Mike and good afternoon.

I'm pleased to announce that Q3 was a solid quarter for Adobe.

Revenue was $602.2 million, near the higher end of the target range we communicated at the outset of the quarter.

In addition, non-GAAP diluted earnings per share were $0.29, exceeding our original target range of $0.25 to $0.27.

Highlights in Q3 included record revenue for our LiveCycle Enterprise service solutions as well as continued momentum for InDesign and our Digital Video solutions.

In addition, we achieved another quarter of strong revenue for our Acrobat family of products.

This is especially pleasing when you factor in both normal Q3 seasonality as well as the anticipated release of the next major version in Q4.

I'll now turn the call over to Randy to provide a review of our Q3 financials.

Randy?

Thanks, Bruce.

Before I review our Q3 financial results, I'd like to point out that we are not providing combined year ago Adobe and Macromedia results for comparison purposes.

As we previously stated Adobe and Macromedia reported the results on different fiscal quarters which limits our ability to provide accurate comparisons.

Therefore today we will compare our Q3 fiscal 2006 financial results to our Q2 fiscal 2006 results as well as with preacquisition Adobe only results for Q3 in fiscal 2005.

We also have the challenge of meaningfully comparing our fiscal 2006 results versus our fiscal 2005 results due to acquisition accounting and the implementation of stock based compensation under FAS 123R.

For the quarter of fiscal 2006, Adobe achieved revenue of 602.2 million.

This compares to 487 million reported for the third quarter of fiscal 2005 and $635.5 million reported last quarter.

GAAP net income for the third quarter of fiscal 2006 was 94.4 million compared to 144.9 million recorded in the third quarter of fiscal 2005 and 123.1 million last quarter.

Non-GAAP net income was 171.5 million compared to 146.4 million reported in the third quarter of fiscal 2005 and 189.4 million last quarter.

Non-GAAP excludes as applicable Macromedia acquisition costs, restructuring charges related to the Macromedia acquisition, a charge for the purchase of incomplete technology, stock based compensation, tax differences due to the timing and deductibility of the Macromedia acquisition cost and related charges and stock based compensation and investment gains and losses.

GAAP diluted earnings per share for the third quarter of fiscal 2006 were $0.16 based on 600.9 million weighted average shares.

This compares with GAAP diluted earnings per share of $0.29 reported in the third quarter of fiscal 2005 based on 507.8 million weighted average shares and GAAP diluted earnings per share of $0.20 reported last quarter based on 613.8 million weighted average shares.

Non-GAAP diluted earnings per share for the third quarter of fiscal 2006 were $0.29.

GAAP gross margin for the quarter was 88.5% compared to 94.4% in the third quarter of fiscal 2005 and 89.7% last quarter.

Non-GAAP gross margin, which excludes the amortization of Macromedia acquisition related costs and stock based compensation was 94.3%.

GAAP operating expenses for the third quarter of fiscal 2006 were 422.7 million, non-GAAP operating expenses which exclude Macromedia acquisition costs, restructuring charges related to the Macromedia acquisition, a charge for incomplete technology related to a small acquisition and stock based compensation were 360.8 million.

Regular employees at the end of the third quarter totaled 5,879 versus 5,678 at the end of the second quarter of fiscal 2006.

The majority of the head count increase from last quarter was in research and development.

GAAP and non-GAAP expenses as a percentage of revenue break down as follows.

Research and development, GAAP, 21.7%, non-GAAP 19.2%.

Sales and marketing, GAAP, 36.1%, non-GAAP 32.2%.

General and administrative, GAAP, 9.5%, non-GAAP 8.5%.

GAAP operating in the third quarter of fiscal 2006 was 110 million or 18.3% of revenue.

This compares to GAAP operating income of 183.6 million or 37.7% of revenue in the third quarter of fiscal 2005.

And 147.9 million or 23.3% of revenue last quarter.

Non-GAAP operating income in the third quarter of fiscal 2006 was 207.2 million or 34.4% of revenue.

This compares to non-GAAP operating income of 183.6 million or 37.7% of revenue in the third quarter of fiscal 2005 and 243.1 million or 38.3% of revenue last quarter.

Other income, for the third quarter of fiscal 2006 was 18.1 million.

Adobe's GAAP effective tax rate for the third quarter of fiscal 2006 was 23.3% and Adobe's non-GAAP effective tax rate was 23.9%, our GAAP and non-GAAP tax rates were lower than targeted due to a benefit from R&D and foreign tax credits included in our fiscal 2005 tax returns that were filed in August.

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

Creative Solutions segment revenue was 328.1 million compared to 357.3 million last quarter.

This decline is consistent with expectations as we discussed at the outset of the quarter related to normal seasonality and customer deferrals and anticipation of the Creative Suite 3 launch next year.

Knowledge Worker segment revenue was 154.1 million compared to 163 million last quarter.

Acrobat revenue grew on a year-over-year basis.

Enterprise and Developer segment revenue was 49.4 million compared to 42.8 million last quarter.

Our LiveCycle, server business achieved record revenue in Q3.

Mobile and device segment revenue was 9.1 million compared to 7.9 million last quarter.

Revenue in this segment continues to be impacted due to purchase accounting from the Macromedia acquisition.

In other, segment revenue was 61.5 million compared to 64.5 million last quarter.

Turning to our geographic segments, the results in Q3 fiscal 2006 on a percent of revenue basis were as follows.

The Americas 52%, Europe 27%, and Asia 21%.

We experienced normal, seasonal demand across all major geographies.

Our trade DSO in the third quarter of fiscal 2006 was 43 days, this compares to 29 days in Q3 of fiscal 2005 and 40 days last quarter.

In regard to our global channel inventory position, we ended the quarter within company policy.

At the end of the third quarter of fiscal 2006, cash and short-term investments were $2 billion compared to 1.8 billion at the end of the second quarter of fiscal 2006.

In regard to share buyback, during the quarter we repurchased 12.1 million shares at a cost of $358.3 million as part of our share repurchase programs.

As part of the share repurchases in Q3, we concluded our $1 billion share repurchase program.

This concludes my discussion on third quarter results.

I will now discuss our Q4 targets.

We are targeting a Q4 revenue range of approximately 655 to $685 million.

In addition we are targeting our Q4 GAAP operating margin of 21 to 24% on a non-GAAP basis which excludes acquisition-related costs and stock based compensation.

We are targeting an operating margin of 37 to 38%.

We are targeting our fourth quarter share count to be approximately 600 to 602 million shares, for other income we are targeting 16 to $18 million.

For our GAAP and non-GAAP effective tax rates we are targeting 26%.

These targets lead to a GAAP earnings per share target range in Q4 fiscal 2006 of $0.19 to $0.22 per share and a non-GAAP earning per share target range of $0.32 to $0.34.

The following is factored in to our Q4 financial targets.

We expect to see normal, seasonal strength in the fourth quarter.

We expect the Q4 launches of Acrobat and our hobbyist products to help deliver strong, sequential growth.

And we expect the weakness we experienced in Q2 and Q3 in our Creative Professionals business to continue until the release of Creative Suite 3 next year.

However, we do expect our Creative business to grow sequentially from Q3 to Q4.

Looking to next year, while we're not providing fiscal 2007 financial targets today, we are anticipating Q1 revenue to decline sequentially from Q4 and we expect Q1 to be the lowest revenue quarter of the year due to anticipation of the Creative Suite 3 launch in Q2.

I'd now like to turn the call over to Shantanu.

Thanks, Randy.

I'll take the next few minutes reviewing highlights in each of our major businesses, starting first with Creative Solutions.

Overall, our Creative business had a sequential decline from Q2 to Q3 that was in line with our expectations.

We attribute the decline to normal seasonality as well as customer deferrals in anticipation of the next version of Creative Suite next year.

InDesign again achieved its best revenue quarter since we launched the product more than 6 years ago and continued to gain key customers.

For example, Topan Printing of Japan is using InDesign as the standard platform for its computer-typesetting system.

Their mission-critical system used in creating magazines and books.

This is a milestone for InDesign adoption in Japan which still relies on proprietary systems in much of the publishing industry.

We continue to be on track to deliver the next version of Creative Suite in Q2 next year.

In our Digital Imaging business, PhotoShop revenue remains steady a year after the latest version shipped.

In fact, full units of PhotoShop grew quarter-over-quarter when factoring in sales of PhotoShop, Creative Suites, the new bundles, and production studio.

Earlier this week, we announced new versions of our Hobbyist products.

PhotoShop Elements 5.0 and Premier Elements 3.0.

These market-leading products will be available separately or together in a single retail package in October.

PhotoShop elements is already receiving accolades from the press.

Shortly after our announcement, it was given an Editor's Choice award by PC magazine which called it, "an essential upgrade", and stated "Adobe has taken a good thing and made it even better".

We continue to be excited about the Digital Video opportunity.

The adoption of production studio and Flash video on the web helped drive 39% year-over-year growth in the quarter.

In addition to the success of production studio, our Flash video server technology continues to gain ground with high profile media and Internet companies.

In July, ABC.com received an Emmy for its streaming player which delivers TV episodes in Flash video.

Reinforcing the importance of video in the online advertising world, a recent Jupiter report stated, "advertisers, will increase adoption of format such as rich media and video at a high rate . and spending on these formats will increase by a CAGR of 21% and 27% respectively".

We believe we are well-positioned to take advantage of these trends.

In our knowledgeable solutions business unit, Acrobat revenue was strong in advance of the launch of the new version achieving year-over-year growth. e-Week named acrobat and PDF to the list of 25 most influential products in the first 25 years of Enterprise personal computing.

In terms of mix, the ratio of Acrobat Professional to Acrobat Standard remained at approximately 1 as to 1.

The next version of Acrobat is on track to ship late this quarter in all major languages.

In our Enterprise and Developer solutions business, we achieved both sequential and year-over-year growth.

Driving this performance was our LiveCycle server solutions which achieved record revenue in the quarter.

Some highlights in the government market include the county of Los Angeles, which will use an Adobe forms solution to route and provide offline access for its personnel action form.

The Belgian Federal Finance Service, which will use Reader Extension server to automate forms processing while making it easier for taxpayers to fill out forms online and India's Ministry of Company Affairs which is rendering all its forms through LiveCycle technology and enabling 700,000 companies to file returns and obtain services.

LiveCycle wins in the commercial market include European financial services firm, UBS AG which is using Document Security server with its e-banking documents and Founders Insurance Company which is using an Adobe form solution to generate prefilled insurance forms to the agents to reduce agent work load and data entry errors.

In addition to key customer reference accounts such as these, we are also benefiting from positive industry analyst commentary.

For example, Forrester recently published its 2006 e-Forms web report and stated "Adobe LiveCycle is a leader in the e-Forms software market".

Last month IKON Office Solutions announced that it will add the LiveCycle family of Enterprise software to its premier partner program, further enhancing IKON's integrated portfolio of document management solutions.

In the mortgage vertical, the property recording industry association which represents local and county recorders for real estate transactions has approved Intelligent PDF Documents as an acceptable standard for an electronics recording.

In mid-June we announced the availability of the Adobe Flex 2 product line.

With Flex, we are equipping developers to build a new class of rich Internet applications with improved usability and effectiveness.

Press response to the Flex 2 introduction has been positive.

InfoWorld stated, "Flex's muscle will help businesses break free of the constraints confining today's web based application delivery".

And Computer World called Flex 2, "A large and impressive product that could have a significant effect on web development in the next few years".

In total, the number of Enterprise transactions in the quarter with licensing revenue greater than $50,000 for server products including LiveCycle, Flex, Breeze, and Flash Media Server was 82.

As part of our strategy to grow the ecosystem around our Enterprise and Knowledge Worker solutions, in Q3 we also announced a joint marketing agreement with Science Applications International Corporation, SAIC, which is a major government systems integrator.

SAIC plans to provide systems integration and consulting services for LiveCycle, Breeze, Flex, and Acrobat.

In our mobile and device solutions business, we continue to make progress with Flashlight and Flash Cast.

For example, Samsung announced the release of its uGo Active home screen based on Adobe Flashlight 2 technology and it will be integrated across Samsung's next generation ultra addition mobile phones.

Adobe's ability to deliver creative and user friendly user interfaces is a critical differentiator for leading device makers and Samsung's uGo showcases this new approach.

With FlashCast, we are excited about the continued success that NTT DoCoMo is having, which is generating continued interest with other carriers around the world.

Finally, we had solid performance for our products in the other business segment including year-over-year growth once again in our PostScript business.

We also had several key partner and technology platform announcements during the quarter including a multi-year distribution agreement with Google to distribute the Google tool bar with various Adobe products.

A strategic alliance with Viacom to develop and deliver Viacom's exclusive branded content using the Adobe engagement platform.

Adobe will become Viacom's preferred technology provider for rich media authoring tools and interactive online video solutions enabling Viacom to deliver content from its television, motion picture, and digital properties to online and mobile audiences.

And the availability of Flash Player 9, which provides a more secure, lightweight, robust run time environment for rich media and enterprise ready rich Internet applications.

This concludes my comments.

I will now turn the call back over to Bruce.

Thanks, Shantanu.

It's clear we are entering a very exciting time for Adobe.

With the majority of the Macromedia integration behind us, we're now embarking on one of the richest periods of new product introductions in the Company's history.

With solutions that support a broad range of customers and leverage key market trends.

It began this week with the launch of PhotoShop Elements and Premier Elements for our hobbyist customers, which will take our digital imaging leadership to an entirely new level.

Later in the quarter, we will release a major upgrade to Acrobat delivering new features that will enable us to drive even deeper adoption of the product among millions and millions of knowledge workers around the world.

And finally, with the next versions of our Creative products launching in the spring, we'll release our best offerings ever, which will enable our customers to deliver rich content for print, web, or video across a variety of platforms and devices.

This schedule of product releases combined with the momentum we are having in our video, enterprise, and mobile businesses, translates into an exciting future for Adobe.

Thank you for joining us today, I look forward to seeing many of you at our max conference next month.

Mike?

Thanks, Bruce.

Before we start Q&A, I would like to go over a few logistical items.

We will provide our regular Q4 interquarter update press release on Tuesday, October 31, before the market opens.

Again, that's Tuesday, October 31, before the market opens.

Earlier this week, an invitation was sent out to attend Adobe Max user conference in Las Vegas in October.

The invitation is a special offer for Adobe investors and analysts to attend the conference for one day.

Please call or e-mail Adobe Investor Relations for more information.

Looking to next year, we have tentatively set our next financial analyst meeting date.

We'll host the meeting in San Jose on Wednesday, January 31.

We have posted several documents on our Investor Relations web page related to our earnings report today.

They include today's earnings release, our updated data investor sheet, and a table providing reconciliation for GAAP to non-GAAP financial data.

To access these documents, and other investor related information, you can go to our website at www.adobe.com/adbe.

For those of you who like to listen to a playback of today's conference call, a web based Breeze archive of the call will be available from the IR page on Adobe.com later today.

Alternatively you can listen to a phone replay by calling 800-642-1687.

Use conference ID number 5620434.

Again the phone number is 800-642-1687 with conference ID number 5620434.

International callers should dial 706-645-9291.

The phone playback service will be available beginning at 4 p.m.

Pacific time time and ending at 4 p.m.

Pacific time on Monday, September 18, 2006.

We would now be happy to take your questions.

Operator?

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Steve Ashley with Robert Baird.

Great.

Do you guys plan to take any steps whether it be marketing or promotional to bolster the demand of CS2 as we get closer and closer to the release of CS3?

Steve, this is Shantanu.

So what's traditional is every time we are late in a cycle for our existing products, what we do is we continue to make sure that people who haven't yet moved to the existing version, we do do marketing to try and make sure that we provide for them the benefits of the product.

So yes, we will do what we have traditionally done, which is continue to make sure we target those who haven't yet standardized on the platform.

As you're also aware with the Creative Suite, as InDesign continues to be adopted by more customers, we find them standardizing on the platform.

And finally, we also see people using video and therefore using our higher-end bundles.

The other thing to remember is that in Q4, one of the things we will do is update the bundles with the new version of Acrobat and that should also help the Creative customers because the new version of Acrobat will be [Inaudible] compliant.

The other thing to keep in mind, Steve, is that many of our larger customers ending up buying licenses and many of them buy maintenance that they buy the currency S2 under the maintenance program, they actually get a free upgrade to the S3.

And just in the enterprise developer space, the strong LiveCycle performance, do you think that was tied to just government and government budget flush or was the strength beyond that?

We've actually been fairly pleased with our performance in the enterprise space.

What we are finding, Steve, is the message that we've been communicating about helping enterprises automate their businesses is starting to resonate.

We have more and more customer references and successful customer references.

The SAP relationship continues to deliver.

We had a strong quarter.

And as we get the combined field organization from the integration of Adobe and Macromedia now talking about the combined message of the benefits of both LiveCycle and Flex, we think that's also beginning to take effect.

So all in all, a strong quarter.

Certainly, in North America as you can imagine, there's some of the business happens with government, but government end is also the end of September.

Some of that is in our Q3.

Some of that will be in our fiscal Q4.

Congratulations on the strong execution, thanks.

Thank you.

Your next question comes from Thomas Ernst with Deutsche Bank.

Hi.

Can you hear me?

Yes.

Okay, sorry.

This is Joseph Boyle actually covering for Tom tonight.

The first question we have here is just trying to understand a little bit how the Microsoft Vista launch is going to effect your sales.

And what is going to be more important, the fact that some PC OEMs will be packaging Adobe applications together with Vista, or maybe there's going to be more traction in the quarter following the Vista launch?

Can you help us a little bit there?

Yes, unlike the migration from the Macintosh G5 and G4 chips to Mactell, the migration from Windows XP to Microsoft Vista for our customers will be a much more seamless migration.

Fortunately based on everything we know today, based on the data that we receive from Microsoft, the current version of the Adobe products will work just fine in a Vista environment.

So that is less of an issue for us.

What we suspect is the early adopters of Vista will be consumers -- people who are buying new CPUs, the bulk of our revenue is dependent much more on business people than on consumers per se.

Okay.

That does make sense.

And if I'm allowed I'll ask a follow-up question on Microsoft.

We saw recently on the press that Microsoft is going to make available an add-on to enable Office 2007 to save PDF.

Can you update us on what the state of on your discussions with Microsoft on that topic?

Yes, first of all the news that you recently read is not new news.

That's something that Microsoft talked about a few months ago.

Fortunately for Adobe, we have for many years been anticipating the creation of PDF to becoming much more of a commodity.

And over the last number of years, we've been adding capabilities into Acrobat like digital signature, like highlighting, like annotations, like forms, and other collaboration features that makes the value creation of Acrobat or the value of Acrobat much more than just PDF creation.

In fact when you look our product line today, we have three products in the family, actually four.

We have Acrobat 3D, which is a high end product, we have Acrobat Professional, we have Acrobat Standard, which is a base level product and then we have something called Acrobat Elements, which is PDF creation only.

When you look at the revenue at those four products, Acrobat Elements is a very, very tiny portion of that overall revenue percentage, certainly significantly less than 5% of our overall business, probably closer to 1 or 2%.

So we think that the impact of Microsoft doing PDF creation in their applications or in their operating systems is not a major risk to Adobe.

There is one caveat to that, which is Microsoft is a monopoly, and obviously if they unfairly take advantage of their monopoly, that could be a risk for Adobe.

Okay.

Thank you very much.

And congratulations, guys.

Thank you.

Your next question comes from the line of Jay Vleeschhouwer with Merrill Lynch.

Bruce as you point out you're on the verge of multiple important updates to the key product lines.

I'd like to ask you though in two ways at least I think the Company is different from before in terms of product strategy and market strange.

One has to do with product segmentation.

You've done some of that already with Acrobat and on the Creative side.

It seems likely that you'll do even more of that starting in the spring and secondly, you were addressing as Macromedia had begun to do before the acquisition the developer market, you're doing that now, of course with Apollo.

The question is could you talk about how well you think your sales and development and market resources and capabilities are aligned to all those new strategies that seem to overlay the traditional Adobe, let's say in terms of updating the product lines?

We're very fortunate, Jay, in that the bulk of our revenue today is dependent much more on the quality of the product and our ability to market that product to constituents or customers that are already familiar with us and are very loyal to us.

Where we are dependent upon a direct sales organization is in those areas that today represent a relatively small piece of our business and that tends to be the revenue associated with our enterprise business and our mobile business.

And as I said, fortunately that's not a large piece of the business today.

So what we've been doing and Shantanu has been working on and spending a lot of time on is integrating the Macromedia sales organization with the Legacy Adobe sales organization in such a way that we will develop and continue to develop that capability for the future.

It's a great sign to see that the LiveCycle business had a record quarter despite the fact that we have not yet fully completed the integration on the sales side that we truly would like to have in terms of completion.

So, I think that's a comfortable position to be in.

The other thing I'll point out is we are a much more diverse business than we were in the past, certainly product segmentation has helped us a lot, you'll continue to see product segmentation, there'll be a number of SKUs or different products associated with the Creative Suites.

We like the success that we've had with the Creative Suite Standard and Creative Suite Premium, we like the success we've had with Acrobat Standard and Acrobat Pro.

We're certainly looking at opportunities in the PhotoShop arena to do something similar.

No announcements at this time.

What's nice about our diversification, the fact that we now span everything from the hobbyist all the way up to the serious enterprise developer is our revenue is no longer dependent on any one segment the way it was in the past.

Certainly we still have the strong creative community and that will always have an impact on our business, at least over the next couple of years.

Taking a shorter term view and not just a long-term view.

To what extent have the new bundle, the ones introduced immediately after the merger been able to offset some of the weakness in CS or might continue to be able to offset the weakness in CS, particularly as we go into the February quarter?

Jay, as we thought about the Creative business as Randy also said in his prepared remarks, what we do expect is sequentially moving into Q4 we expect a slight uptick as it relates to the fact that we will have the new Acrobat bundles.

However, we continue to expect that people will delay purchases whether it's because of the Mactell issue or in anticipation of CS3.

Having said that, the web bundle, which is the -- a super bundle so to speak that we have today.

A combination of both Creative Suite as well as Studio, continues to perform very well, which really means to us that we are finding creative people want to standardize on the entire platform.

And so let me also state upfront that if you look at the creative revenue cycle over cycle, we have seen significant growth, which means our core strategy of getting people to standardize on the Creative platform is working.

Let me -- I want to make sure that we're clear on what Randy had said at the beginning or provide a little bit more color around that.

So what Shantanu said is we will see a small sequential increase in the Creative Suite business that will do -- be due predominantly because of the seasonality as well as the addition of the Acrobat Pro in those suites.

Clearly Q1 will be a more challenging quarter for us.

The -- we will, we expect to see a decline in the Creative business because it is the quarter before CS3 and because of the Mactell issue that we're dealing with.

Offsetting that to some degree, will be Acrobat, which as we said was shipping late this quarter, which means we'll continue to see some benefit in Q1 and beyond Q1.

And we continue to see strength in our video business as well as some of the point products like InDesign.

But with that said, we do expect Q1 to be the weakest quarter of the fiscal year next year.

And it will be down from Q4, at least that's what we're currently anticipating.

And lastly, a quick question for Randy, can you comment on how you're doing in Japan?

Well, Q3 as I said in my prepared remarks there was, we expect to experience normal seasonality in all three geographies, which included weakness in terms of just the seasonality in North America, Japan, and Europe.

And Japan was in line with that expectations in terms of seasonality.

We certainly expect Japan as well as the rest of the geographies to recover in terms of strength from the seasonality going into Q4 here.

Thank you.

Your next question comes from the line of Adam Holt with JP Morgan.

Good afternoon.

I had two questions on Acrobat.

Was the strength in the current quarter in terms of the year on year growth in your opinion largely driven on the enterprise side by people trying to buy in front of the release to lock in upgrade rights?

And secondly and along that line, you had a pretty nice increase in deferred revenue, were there any changes to the maintenance program in front of the 8 release?

Thanks.

Adam, the increase in Acrobat.

Acrobat has actually shown momentum ever since we introduced the current version of the Acrobat product.

We continue to have Acrobat growth being driven by full units, which is new people who are adopting the Acrobat platform to share information reliably.

So we continue to see enterprises adopt Acrobat, but I would say Acrobat strength was really across the board.

And in terms of deferred revenue, yes, I think this is the third or fourth quarter here in a row that we've seen an increase in deferred revenue.

Ended up in a total of $125 million at the end of Q3.

And we expect that to continue, that kind of trend going forward as our model shifts more and more to enterprise and license based revenue.

And in terms of the maintenance program, I don't believe we made any significant changes, we ended up slightly tweaking our licensing prices to our customers beginning in August, but I don't believe we made any major changes to the maintenance program.

And just a follow-up if I could.

When you say ship late in the quarter, we should assume that is the second half of the fourth quarter?

We haven't been specific about the date.

So other than that, we don't want to preannounce the product.

We typically will preannounce the product 30 days prior to the actual ship or when we usually announce the product we get more specific.

So not that -- it's not fair to our customers, we don't want to -- Acrobat has been a strong performer for us so we don't want to set inappropriate expectations.

Terrific.

Thanks for the help.

Your next question comes from the line of Rick Sherlund with Goldman Sachs.

Thanks, I had a couple quick questions.

If you could touch on cost of services, you seem to have shown some good improvement there, and if you could touch on DSOs why we've seen that year-over-year increase?

I think you mentioned it last quarter, it's still up.

I'm not quite sure I recall.

And Google, when do we see a contribution there?

And how expensive that might be?

Okay.

Well, let me I'll the first part here and I'll let Shantanu take the Google question.

In terms of cost of sales gross margin, it come out pretty much in line with expectations.

Last quarter we indicated it moved favorably for us.

And that's basically as a result of the trend that we have moving from less shrink wrap towards more license going forward.

We have a couple of favorable things in there that we pointed out that going forward from an expectation point of view expect Q3 to be better than Q1, but probably not quite as good as Q2 and that's pretty much how it come out.

So going forward I would expect, I'd model this, although we don't give specific guidance pretty much in line with what you see as we had there in Q3.

So, Rick, was your question around Google?

I didn't quite catch that.

Yes, Google.

Are we going to see any material Google revenues?

And if so, when?

So starting with Q3 actually revenues from Google are factoring in what we report as the other segment and the terms are clearly confidential, but they're factored into the targets that you see for Q4.

And will be in the targets that we give beyond that in 2007.

Okay.

I think you asked also about DSO here.

Yes.

I -- the DSO did creep up there.

And it was actually as a result of, as we pointed out, August was a pretty important month and it tended to be back end loaded, and as a result, that's going to SKU the DSO up.

With that said, I really think long-term we're in the -- we're in the range of what I would model that out.

As we continue to move, again, more and more towards enterprise, there we've -- you're going to see this in this range.

I can say that, I reviewed in detail our accounts receivable and very high quality receivables, practically all current.

And what little's not current is certainly not more than 30 days past due there.

So overall I feel very good about the receivable position and this all has to do with the SKU of the quarter.

Did accrued inventories increase in the channel as I recall it's not counted revenue from increased inventory levels?

That's correct.

You made the statement that inventories increase in the channel, is that what you--?

Yes.

If there were an increase in inventories in the channel late in the quarter it doesn't count as revenue as I recall.

That's correct.

And let me just clarify, Rick.

We're within our channel inventory policy.

So any inventory that was shipped to the channel that was above our inventory policy would not be recognized.

If it's within our inventory policy, we certainly recognize it, but it's a policy we've had in place for a number of years now and it's a policy that's reviewed by both the audit committee and the external auditors.

And when Acrobat 8 ships, do you simply switch the inventory of the old product for the new product?

Yes, what we'll end up doing is at a certain point in time once we announce the product, we will start drying the channel out and at the time that we ship Acrobat 8 we'll take back the -- or whatever we decide to call the product, we'll take back the current Acrobat 7 product.

Okay.

Thank you.

Your next question comes from Sasa Zorovic with Oppenheimer.

Yes, thank you, could you please tell us how the linearity remained within the quarter?

Namely did the quarter remain fairly linear through the duration of the quarter?

For the most part, Sasa, when we look at the quarter, Q3 tends to be, August tends to be strong, especially in the last couple of weeks of the quarter and that's because Europe comes back from vacation.

Modular that it was in line with what we expect, otherwise, which is fairly linear.

The enterprise business, which is a small fraction of the business, you do tend to see that later in the quarter like traditional enterprise software.

Has that also been continued into the September quarter that kind of end of August sort of linearity?

And then also in terms of the Americas being up mostly, well, in the past, except for just a couple of times when it was down -- was up, it's mostly down in the quarter, what do you attribute really to the Americas then being up sequentially?

So in terms of color on September we'll provide more color at our intraquarter update on October 31.

In terms of North America, if you look at year-over-year, it's pretty much in line, it runs about 51, 52% of our business this time of year because Europe goes down this quarter because they're closed for a good chunk of the quarter on vacation, as well as we have a pickup in North America in our education business.

That is typical of every other Q3 that we've experienced around here.

But usually Q3 would tend to be down from Q2 even in the Americas, this time it wasn't.

Keep in mind -- so, you're saying that the North American business was not down Q3 over Q2?

That's right.

Yes, I think as Shantanu said we saw a couple of areas of strength in particular LiveCycle due to the maturity of our go to market, it is much more successful in the U.S. for us than it is in other parts of the world we did have a very strong education season.

Great, thank you.

Your next question comes from the line of Ross MacMillan with Jefferies.

Yes, thank you, can you just talk a little bit about how you're gauging the level of pent up demand ahead of CS3, how do you guys think about that in terms of a demand buildup?

What things do you look for?

What are you trying to understand from the channel?

Well, it's really early in terms of getting any channel feedback really on CS3.

Because we haven't announced the product, we haven't really talked to the channel about the features.

At this point in the cycle what we really do is as we are talking to a number of our early customers, customers who have been loyal to the Company and who have been using the products, what we do is share with them everything that we're doing in terms of both the features that we do to enhance productivity of people using them as well as the integration features.

There's a tremendous amount of excitement associated with a couple of things.

First, it will be the first release of the products, which combine the Macromedia, former Macromedia products and Adobe products.

So the ability for us to have file format compatibility between these applications is very interesting to our particular customers.

Second, there's a lot of interest associated with the fact that we can now make the work flow more seamless and refocus data whether that's from the print site or the website or from the web to wireless devices as well as integrate the entire video work flow and we have talked about how video is really driving a lot of our business.

There's also a lot of excitement around the fact that it will be the first version of the products that will be Mactell compatible and given the higher performance that we expect from the Mac CPUs it will enable people who are using our products to be significantly more efficient and productive.

And when Vista is around also in the past, what we have seen is when there has been new hardware purchases, people tend to then buy software.

So given a lot of feedback that we have from our customers, it feels like we're on the right track with CS3.

That's great.

And then maybe just a very quick follow-up for Randy, you hit the high end of the range on GAAP EPS, but you beat by $0.02 above the high end of the range on non-GAAP.

I understand the tax was on both.

So what was the additional delta on non-GAAP to beat by $0.02?

Thanks.

Well, first off, I think, we did a very good job at the Company of controlling expenses.

And the revenue was the top third of the range there and expenses it was -- as I pointed out, August was a quarter that -- a lot of our revenue depended upon August.

Therefore we did a good job at controlling expenses throughout the quarter.

And I think from that aspect, that got us to the top end of the range or the $0.27 number that we had there.

In addition to that, we had three things that were favorable in terms of non-GAAP on the income statement.

One of those was our tax rate.

And it turned out to be lower than expected.

And that was as a result of us achieving some additional credits, R&D, and foreign tax credits that were more favorable than the position because we filed our return during the quarter.

Second thing was other income, come in higher than we had guided to and that was as a result of some favorable foreign exchange transactions we entered into through the quarter.

And the third thing was our share count come in lower than expected.

And that was primarily as a result of having a lower than stock price than we baked into the calculation, therefore we had lower shares exercise in our stock plan and we did go into the marketplace and buy some shares as I pointed out, as well which brought that down.

So those three things combined to enable to take that from roughly from $0.27 to $0.29.

What's pleasing to me is even without those one-time expenditures or savings, we were able to still come in at the high-end of our EPS target range.

Great, thank you very much.

Your next question comes from the line of Heather Bellini with Union Bank Switzerland.

Hi, thank you.

I was wondering if, Bruce, you could give us an idea on two fronts.

With the Acrobat upgrades -- what would be a reasonable expectation for comparing this upgrade cycle to say Acrobat 7?

And then I have a similar comment or similar question on the creative side of the business given all the things that Shantanu just mentioned in terms of the excitement around the Creative products that you're going to be releasing in the spring.

Can you give us a little bit of a sense on why or why not this cycle for the Creative product shouldn't see a greater acceleration than what you've seen say with CS2?

Yes, let me comment on the Creative piece first?

My belief based on everything Shantanu explained, but based on the feedback that I've heard given the fact that the time between the last release and this release is greater than typical because of our desire to do the integration and the Mactell work at the same time.

I believe this will be a better release, a more significant release than the previous two versions of the Creative Suite.

There will be a -- I believe a pent up demand because of all of the factors that Shantanu talked about.

I think back in 2004, I looked at the, how well the first Creative Suite did factoring in, obviously the fact that this will ship in Q2 not at the beginning of the year.

I'm looking for a stellar performance from that release.

In terms of the Acrobat upgrade, I would say that and when you look at features, functionality, benefits to the user.

It is equal to or greater than what Acrobat 7 was to the then version of Acrobat 6.

So the next release of Acrobat will even be more feature rich than the previous one over the one at that current time.

Okay, so I just want to clarify.

For CS3 you're saying you think it will be a better release than both CS1 and CS2 in terms of the impact to your business?

Absolutely, just because of everything that Shantanu talked about.

This is a killer release.

The point products have some features that are must-haves, the integration, people are waiting.

They use both the former Macromedia products and the Adobe products in the same work flow and they're waiting for integration.

They're on the sidelines waiting for a Mactell compliant release.

There is a lot of pent up demand and I believe that a lot of the revenue that we're not getting this quarter that we're not going to get in Q4, that we're not going to get in Q1 against the Creative Suite, the current version of Creative Suite will show up in Creative Suite 3 over its life.

In terms of Acrobat, the only thing I would caution you on is, when we released the last version of Acrobat 7, the last version -- the current version of Acrobat, which is Acrobat 7, we had a full quarter.

In this case, it's going to be late in the quarter, so the benefit will be over time not all in one quarter.

And can you just give us the top three, I guess, functionality enhancements to Acrobat 8 that will get people to upgrade?

There's many that say you're getting to the point in your life cycle of Acrobat that you're becoming like Office and do you have to be on the latest release.

Can you just give us what the top three improvements for the product are that you think will drive people to upgrade?

As soon as we publicly announce the product, which you suspect should not be too far off we'll be more than happy to talk about the dynamite features that are in there.

Okay, great, thank you.

Your next question comes from the line of John McPeake with Prudential.

Thank you.

Bruce, as I go out on the web, I'm noticing more and more that Flash is replacing, Real Media and QuickTime as the preferred method for video delivery.

And I was hoping you could talk a little bit about what -- how you guys are able to monetize that opportunity because I know a lot of these sites, may uTube or even video.google aren't paying you much in the way of licenses for the service side products.

And I'm interested to know what kind of benefits they could derive from some of those products and also how that might pertain to some of the cashing services like Akamai out there?

Yes, so there's three ways we make money in the video business.

The first is we have a collection of authoring, editing, enhancement tools that are part of the production suite that we sell as standalone products like Adobe Premiere, Aftereffects, Adobe Edition and so on that -- as well as Flash Authoring that people use to create this content, edit this content, enhance the content, and package it up for delivery.

That's one way and as we said earlier, the year-over-year growth this quarter was 39%.

A lot of that has to do with the dynamics that you just talked about.

The second way we make money is we have server technology that allows you to take the Flash file format Swift, and put it in such a way where you could stream it in a much more efficient way taking advantage of all of those Flash players out there.

We sell that server either as a stand alone server directly to those people who want to stream their video to the media houses or many of them actually go through service providers like an Akamai or a Limelight and they use our server technology and we get a cut of that business based on the amount of video that is streamed.

The third way that we make money in the video area is through the hobbyist with products like Premier Elements, we're making it easier and easier to edit and package up video so you can use in conjunction with sites like [UToo] and others.

And how significant is that second source?

The Akamai's and the--.

Today it's a relatively small piece of the business, but it's one that we expect to grow significantly over time.

Okay.

Great, thanks a lot.

Your next question comes from Gene Munster with Piper Jaffray.

Congratulations.

And when you look at the timing of Akamai, you've been very clear it's late in the quarter.

When you say late, are you referencing all versions?

Or is it late for English is going to be late and the subsequently the low cost versions?

Gene, the English version will ship first late in the quarter.

We do expect the other major tier 1 languages to also ship in Q4.

And then on the -- you mentioned the availability of -- just to clarify, the Mactell version, the next version of Acrobat will be Mactell enabled that will be bundled in CS2 essentially, but CS2 obviously is going to remain not optimized from Mactell, is that correct?

That's correct, Gene.

Okay, great, thank you very much.

Your next question comes from Michael Mankowski with Tier 1 Research.

Thank you for taking my call.

Have you seen any change in the competitive environment whether it's Microsoft or maybe even Corel, any commentary there, please?

Michael, we continue to make sure that we look at all competitors that we have in our space.

Certainly as it relates to our Creative products as we continue to provide Creative features and better integration, that's where we continue to believe will be our differentiation and I think it's our breadth of our products in that particular space which turn people to look to Adobe for solutions.

Microsoft is always going to be a competitor in many areas, but I think we've also demonstrated that we know how to compete effectively with them as we continue to innovate in our products and I think Bruce talked earlier about the fact that depending on what Microsoft does, they're a competitor that we have to continue to pay attention to.

Your next question comes from the line of Trip Chowdhry with Global Equity Research.

Thank you and very good execution.

I was [Inaudible] a few developments and they seem to be using VectorWorks for 2D 3D graphics.

I was wondering if you can give an insight like how does Acrobat 2D 3D compete with them or do you think their not competing products maybe add on?

Any color on that?

In the VectorGraphics space, as we look at people who are using vectors for creating whether it's packaging or information that goes into newspapers, magazines, I think it's fairly clear that Illustrator is the product that most of our creative professionals use in the work floor as well as all the way out of PDF.

Illustrator by far I think in the creative space the product that people look towards.

Acrobat enables us to store any vector that you might have created within any particular application.

And recently with Acrobat 3D, in addition to 2D, we also now have the ability to store three dimensional.

Certainly there are a number of other competitors in the space, however for the creative community, Illustrator tends to be the product they rely on the most.

And if they want to share that information reliably, they tend to use Acrobat rather than other products and PDF as a file format.

Excellent.

Thank you.

Your next question comes from the line of Brent Thill with Citigroup.

Thanks and good afternoon.

Regarding the operating margin versus top line revenue growth, how are you thinking about balancing that?The margin guidance for Q4 is flat and understandably into the product cycle, but how do you look at into the next cycle balancing?

And which one would you favor into the next cycle?

Yes, Brent this is Bruce.

We're not going to provide specifics on guidance for '07 or beyond at this point in time.

We'll -- our intention is to do that at the December earnings call.

And of course for long-term we'll share much more with you at the January analyst meeting.

What we'll do is -- what we've typically done is to make sure that we're investing adequately to fuel our future growth.

This is a company with many, many growth opportunities in front of itself, the explosion of digital content is happening, and we are well positioned and we want to make sure that we can invest enough to continue to grow double digits for many, many years to come.

So not today, not going to comment specifically on the direction in the -- on the margins, clearly Q4, we want to invest enough to launch the new version of Acrobat as well as to begin to prepare for the launch of CS3, but as it relates to fiscal year '07 and beyond we're not going to comment other than what I've already stated.

Okay.

And just a follow-up by revenue by channel.

Back at the analyst day you mentioned that distributor shrink wrap has been declining for I think the last six years and volume licensing continues to grow given potentially better visibility into your business.

Can you just give us a sense of what percent on volume licensing and how that's been shifting over the last -- over the year?

So Brent again, without giving specifics I can say that we continue to see the trend move towards licensing and we believe that that's a trend that will continue.

I think it reflects both enterprises wanting to do business with Adobe in a more meaningful fashion, it helps us get to know our customers better, as well as from a cost of goods perspective, certainly it's better than the shrink side.

Having said that, one would expect that when we launch Acrobat 7, we will see, or when we launch the next version of Acrobat, the shrink will be a more material part of the business at the time of launch.

Thanks.

Your next question comes from the line of Steve Lidberg with Pacific Crest Securities.

Hi, this is David in for Steve.

Just wondering if you could provide a little commentary on Apollo, what kind of response you're seeing from the developers?

Where you anticipate it going when it's released in '07?

And what kind of momentum we could see when it is released?

Thank you.

Apollo is multi-year investment that we're making and it really is associated with the fact that we believe that the web today has fundamental limitations and people are looking for a new way to create a set of rich and attractive applications that work online and offline on the web.

Clearly Apollo will take advantage of the reach that we already have at both the Adobe Reader as well as the Flash player and also combine the best of what exists in HTML into this entire environment.

At this point really it's working with a number of of key developers, getting their feedback, the feedback's being very positive.

But at this point I'm not going to communicate further.

Clearly at the Macs developer conference we'll talk in more detail about what our plans for Apollo.

Thanks very much.

Operator, we'll take two more questions, please.

Your next question comes from the line of Walter Pritchard with Cowen.

My questions have been answered.

Just wanted Randy one question for you.

If you look at the marketing line, or the sales and marketing line it's been pretty flat for the last three quarters.

I'm just trying to get a sense of as we move into these product release periods of the current 194 or so million in non-GAAP sales and marketing expense.

How much of that is strictly head count related?

And how much of that is sort of variable marketing expense that we'd expect to probably ramp up here over the next couple of quarters?

Yes, that's something that we don't provide details on.

Okay.

Thanks, guys.

Your final question comes from the line of Yun Kim with Pacific Growth.

Thank you, I just want to get some clarification on your statement regarding the Acrobat 8 ship date happening later in the quarter.

Since you are planning to announce the product release 30 days before the ship date or so I think that's what you mentioned in the call,

I am assuming that the customer can start ordering the product before the ship date once it is announced?

And would you expect to have some visibility into the Acrobat that's ordered but not shipped when you issue your intraquarter update on the 31?

Again, typically what we do is -- I think all of us will have to wait until we announce the product.

Once we announce the product, prior to the public announcement of the products, we do notify the channels so that the channel is aware of this information.

And the day we announce the product we also start taking orders directly on the web.

So certainly once the product is announced, we will start to get visibility both from our channel partners and directly on the web.

A sense of the demand for the product.

But at this point we're not committing to any other piece of information.

However, we should by the intraquarter update have some sense for what the demand is or should be.

Great, thank you very much.

Well, this concludes our call today and we thank everybody for joining us.

This concludes the Adobe Systems Q3 fiscal year 2006 earnings conference call.

You may now disconnect.