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Executives

Mike Saviage -

Mark Garrett - Chief Financial Officer and Executive Vice President

Shantanu Narayen - Chief Executive Officer, President and Director

Analysts

David Hilal - FBR Capital Markets & Co.

Ryan Lee

Adam Holt - Morgan Stanley

Chad Bartley - Pacific Crest Securities, Inc.

Brent Thill - UBS Investment Bank

Philip Winslow - Crédit Suisse AG

Ross MacMillan - Jefferies & Company, Inc.

Steven Ashley - Robert W. Baird & Co. Incorporated

Walter Pritchard - Citigroup Inc

Brad Zelnick - Macquarie Research

Blair Abernethy - Stifel, Nicolaus & Co., Inc.

Michael Olson - Piper Jaffray Companies

Kash Rangan - BofA Merrill Lynch

Adobe Systems (ADBE) Q1 2011 Earnings Call March 22, 2011 5:00 PM ET

Operator

Good day, everyone and welcome to Adobe's Q1 Fiscal Year 2011 Earnings Conference Call. As a reminder, today's call is being recorded. At this time, I'd like to turn the call over to like Mike Saviage, Vice President of Investor Relations. Please go ahead, sir.

Mike Saviage

Good afternoon, and thank you for joining us today. Joining me on the call are Adobe's President and CEO, Shantanu Narayen, as well as Mark Garrett, Executive Vice President and CFO. In the call today, we will discuss Adobe's first quarter fiscal year 2011 financial results. By now, you should have a copy of our earnings press release, which crossed the wire approximately one hour ago. If you need a copy of our press release, you can go to adobe.com under the Company and News Room 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, March 22, 2011, 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 the Forward-Looking Statements Disclosure in the earnings press release we issued today as well as Adobe's SEC filings.

During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in today's earnings release and on our Investor Relations website in the Investor Data Sheet. Call participants are advised that the audio of this conference call is being broadcast live over the internet in Adobe Connect and is also being recorded for playback purposes. An archive of the call will be made available on Adobe's Investor Relations website for approximately 45 days and is the property of Adobe Systems. The audio and archive may not be re-recorded or otherwise reproduced or distributed without prior written permission from Adobe Systems. I will now turn the call over to Shantanu.

Shantanu Narayen

Thanks, Mike, and good afternoon. I'm pleased to report we delivered record revenue of $1,028,000,000 in Q1, with non-GAAP earnings per share of $0.58. This represents our sixth consecutive quarter of sequential revenue growth. Adobe's vision for transforming how the world is creating, measuring, and delivering digital experiences is resonating with our customers, and our solutions are enabling us to target large addressable markets that are fueling our growth.

I'd first like to turn the call over to Mark, who will discuss our performance in the quarter and provide our financial targets for Q2. Following that, I'll discuss some business highlights, and then we'll take your questions. Mark?

Mark Garrett

Thanks, Shantanu. For the first quarter of fiscal 2011, Adobe achieved record revenue of $1,028,000,000. This compares to $858.7 million reported in Q1 fiscal 2010 and $1,008,000,000 reported last quarter. Year-over-year, this represents 20% revenue growth. As a reminder, in Q1 fiscal 2010, we had an extra week of revenue due to our 52-53 week financial calendar. This extra week benefited our revenue in the year-ago quarter by approximately $35 million, and normalizing for the extra week results in high year-over-year growth rates across our business.

We entered the first quarter with 5% of reported Q4 revenue in shippable backlog, and we exited the first quarter with no shippable backlog. Q1 GAAP operating expenses were $617.7 million compared to $592.5 million reported in Q1 fiscal 2010 and $613.8 million last quarter.

Non-GAAP operating expenses in Q1 were $539.5 million compared to $498.7 million reported for Q1 fiscal 2010 and $535 million last quarter. GAAP operating income in Q1 fiscal 2011 was $302.3 million, or 29.4% of revenue. This compares to GAAP operating income of $176.8 million, or 20.6% of revenue in Q1 fiscal 2010, and $286.9 million, or 28.5% of revenue last quarter.

Non-GAAP operating income in Q1 fiscal 2011 was $400.1 million, or 38.9% of revenue. This compares to non-GAAP operating income of $289.3 million, or 33.7% of revenue in Q1 fiscal 2010, and $384 million, or 38.1% of revenue last quarter. Adobe's effective GAAP tax rate in Q1 was 18% and the non-GAAP tax rate was 22%. Our GAAP tax rate was higher than targeted due to a one-time charge related to our acquisition of Demdex in Q1. Q1 GAAP net income was $234.6 million compared to $127.2 million reported in Q1 fiscal 2010 and $268.9 million last quarter. Non-GAAP net income in Q1 was $298.1 million compared to $211.7 million reported in Q1 fiscal 2010 and $285.7 million last quarter.

GAAP diluted earnings per share for Q1 fiscal 2011 were $0.46 based on 511.3 million weighted average shares. This compares with GAAP diluted earnings per share of $0.24 reported in Q1 fiscal 2010 based on 532.6 million weighted average shares and GAAP diluted earnings per share of $0.53 reported last quarter based on 511.9 million weighted average shares.

Non-GAAP diluted earnings per share for Q1 fiscal 2011 were $0.58. This compares with non-GAAP diluted earnings per share of $0.40 in Q1 fiscal 2010 and $0.56 reported last quarter.

I will now discuss Adobe's results in Q1 by business segment. As we explained in December, we have modified our reporting segments for fiscal 2011. Our Investor Relations website contains our Investor Data Sheet, which has updated fiscal 2009 and fiscal 2010 segment results to reflect the changes. Based on our prior business segment classification, Q1 results either achieved or exceeded the segment guidance we provided in December. Using our new FY 2011 business segments, results were as follows: Creative and Interactive Solutions segment revenue in Q1 was $424.8 million, compared to $332.6 million in Q1 fiscal 2010 and $404.8 million last quarter. The strength and adoption of our CS products that we experienced in Q4 continued in Q1.

Digital Media Solutions Q1 revenue was $151.7 million compared to $130.6 million in Q1 fiscal 2010 and $165.9 million last quarter. Photoshop and our video products performed well, with the sequential decline attributed to the normal seasonality of our hobbyist products.

Digital Enterprise Solutions revenue was $286.6 million in Q1 compared to $244.8 million in Q1 fiscal 2010 and $273.3 million last quarter. Within Digital Enterprise Solutions, Knowledge Worker revenue was $181.8 million compared to $165.9 million in Q1 fiscal 2010 and $169.9 million last quarter. Knowledge Worker 10% year-over-year growth was due to Enterprise adoption of the new Acrobat 10 release as well as increases in unit pricing.

Enterprise segment revenue was $104.8 million compared to $78.9 million in Q1 fiscal 2010 and $103.4 million last quarter. The value proposition of our customer experience management offering is resonating with customers, driving strong year-over-year growth, particularly now that our solution includes the Day content management products.

Omniture segment revenue in Q1 was $110.9 million compared to $96 million reported in Q1 of fiscal 2010 and $109 million last quarter. Omniture transactions increased to $1.38 trillion in Q1 compared to $1.32 trillion in Q4 and were up 12% on a year-over-year basis. Omniture revenue diversification continued, with SiteCatalyst at 52% of Q1 Omniture product revenue. Enterprise renewal rates remained at 95% in the quarter. Finally, Print and Publishing segment revenue was $53.7 million compared to $54.7 million in Q1 fiscal 2010 and $55 million last quarter.

Turning to our geographic segments in Q1, results on a percent of revenue basis were as follows: the Americas, 49%; Europe, 31%; Asia, 20%. Revenue in Q1 was driven by strong performance with our Creative, Acrobat and Omniture solutions as well as a rebound in the education market and seasonal strength in Japan.

In Enterprise, we saw some large deals pushed out, adding to what was already a strong Enterprise pipeline in Q2. From a year-over-year currency perspective, FX reduced revenue by $5.9 million. We had no hedge gains in Q1 FY11 and no hedge gains in Q1 FY10. Thus the net year-over-year currency impact reduced Q1 revenue by $5.9 million.

From a quarter-over-quarter perspective, FX reduced revenue by $1.7 million. We had no hedge gains in Q1 FY11 versus $0.7 million of hedge gains in Q4 FY10. Thus the net sequential currency decrease to revenue considering hedging gains was $2.4 million. Employees at the end of Q1 totaled 9,503 versus 9,117 at the end of last quarter. The increase was primarily in sales and marketing as well as in R&D and lower-cost geographies.

Our trade DSO was 47 days, which compares to 40 days in the year-ago quarter and 50 days last quarter. Our global channel inventory position at the end of the quarter was within company policy.

During the quarter, cash flow from operations was $332 million. Our ending cash and short-term investment position was $2.6 billion compared to $2.5 billion at the end of Q4. In Q1, we repurchased approximately 2.5 million shares at a total cost of $83.4 million.

Entering Q2, $41.6 million remains outstanding in open prepayments for stock repurchases. $875 billion of stock repurchase authority remains against the $1.6 billion stock repurchase authorization announced in July of last year. Deferred revenue in the quarter increased by $14 million in the quarter to a total of $443 million.

This concludes my discussion of our financial results. I would now like to comment on our financial targets for the second quarter of fiscal 2011.

Our hearts go out to everyone in Japan. Although Adobe has a very diversified business, Japan is our second-largest country from a revenue perspective, and March is typically our biggest revenue month of the year there due to fiscal year-end spending. Given the uncertain business environment in Japan, we are being prudent and have reduced our revenue expectation for our second quarter by $50 million, or roughly 1/3 of our original Q2 revenue expectation for Japan. With this reduction, we are targeting a Q2 revenue range of $970 million to $1,020,000,000.

By business segment, we expect Omniture and Enterprise to grow sequentially, and we expect all the other business segments to decline sequentially due to the impact from Japan. Geographically, we expect Asia to decline sequentially, whereas the Americas and EMEA are expected to be flat to slightly up.

For margins, we are targeting a Q2 GAAP operating margin range of 24.5% to 27.5% and a non-GAAP operating margin range of 34% to 36%. We are targeting our Q2 share count to be 510 million to 512 million shares. We are targeting non-operating expense to be between $16 million and $20 million on both a GAAP and non-GAAP basis.

For our Q2 effective GAAP and non-GAAP tax rates, we are targeting 22%. These targets lead to a GAAP earnings per share range of $0.33 to $0.40 per share and a non-GAAP earnings per share range of $0.47 to $0.54.

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

Shantanu Narayen

Thanks, Mark. As evidenced by our Q1 results, our strategy is working. Adobe is leading the revolution in how digital experiences are created, managed, distributed, measured and monetized in this multiscreen world. We continue to deliver innovative solutions to a broader set of customers, which is helping to successfully transform Adobe into a more diversified software company with large opportunities for new growth.

As we have previously shared with you, we are focused on three significant growth opportunities: content offering, customer experience management and online marketing optimization, and I'll spend a few minutes covering the highlights from each area today.

In content offering, we achieved strong year-over-year growth with our Creative products, and CS5 continue to perform well. In Q1, we announced general availability of the Adobe Digital Publishing Suite, a comprehensive solution to create, distribute, monetize and analyze digital content including magazines, newspapers and corporate publications. Early demand for the Digital Publishing Suite has been strong across the world, with over 150 titles already made available through app stores including National Geographic, Consumer Reports, Reader's Digest and Vogue.

In addition, corporate publications from Credit Suisse, Mercedes-Benz and Volvo showed that use cases for this solution extend beyond newspapers and magazines, and we expect future publications to include catalogs and other traditional print content that will be migrated for consumption and use on tablets.

The Digital Publishing Suite publishes to Android tablets, including Motorola Xoom and Samsung Galaxy Tab, as well as iOS devices and, in the future, to the RIM PlayBook when it is made available. We will continue to expand our content authoring offerings by providing a mid-cycle release to CS5. The release will enhance our Digital Publishing capabilities, help customers address the multi-screen challenges they face and include new innovative features in areas like HTML and Flash authoring, application creation and video authoring and production.

One of the pillars of our content authoring strategy is to continue to invest in HTML as a key part of our tools portfolio, and we made a Flash-to-HTML converter available last month. We anticipate this tool can be used by Flash designers and developers to extend their work in Flash to platforms that do not yet support the Flash Player.

We continue to see strong momentum for our Flash and AIR technologies. Strategy analytics forecast more than 132 million smart phones, or 36% of all smart phones, will support Flash player in 2011. More than 84 million smart phones and tablets support AIR, including iOS devices, and we expect that to grow to more than 200 million by the end of 2011. In 2010, we also drove 100% year-over-year growth in video streaming via Flash.

Last Friday, we made Flash Player 10.2 available for download on the Android Market. This is a new release for Android devices as well as the beta release for new tablets running Honeycomb. Flash Player 10.2 brings improved performance and a full Web browsing experience, including video games and other interactive content.

In customer experience management, awareness of our solution is growing as organizations are focusing on how to improve interactions with their customers in an increasingly digital world. We're well-positioned to lead this emerging category with new solutions integrating our LiveCycle, Connect and Day products. The Day acquisition, which closed in Q4, has gone smoothly with the new version of the Day CQ5 solution integrating Omniture analytics capabilities already released earlier this month.

This comprehensive Web content management, rich media delivery and social collaboration capabilities helped us close multiproduct agreements with customers such as Daimler, Nissan and General Motors. More importantly, we enter Q4 with a strong Enterprise pipeline.

Our Acrobat business performed well in Q1. Adoption of the new Acrobat 10 product was strong during the quarter, driven by strong Enterprise licensing adoption. In online marketing, momentum continues to be strong in our Omniture business. We had our Adobe Omniture summit two weeks ago with a sellout crowd of 2,600 marketers. At the summit, we announced a new next-generation platform for the Adobe Online Marketing Suite designed to handle increased loads of data from social, mobile and video.

We also launched Adobe SocialAnalytics, a single application that can aggregate all social network and online community activity to determine the impact on sentiment, brand perception and business metrics. We're on pace to measure 5 trillion transactions this year for our customers, with Mobile being the fastest-growing segment of our Analytics business.

Our acquisition of Demdex, a leading data management platform company, closed in January and has already begun enhancing our Omniture offerings with audience optimization capabilities to help advertisers and publishers to maximize their online ad investment. Those capabilities along with the Web content management capabilities acquired from Day Software have served as a compelling value proposition to online marketers and publishers.

While our progress in each of the three growth areas, content offering, customer experience management and online marketing optimization, is exciting individually; the real power is where we see these areas converging to serve our customers' entire workflow. For example, T-Mobile delivers outstanding customer service and saves millions annually by using Creative Suite, the Flash Platform, LiveCycle and Omniture to transform customer experience in stores and online. Likewise, MTV Networks uses Creative Suite and Flash to deliver its online content and Omniture to enhance customer viewing experiences and increase website revenues worldwide. That end-to-end value proposition is Adobe's unique differentiation.

I would like to close by saying how concerned we are about the tragedy in Japan. We are grateful that all our employees in Japan are safe and hope that the situation improves soon. Given the uncertain business environment in Japan, we chose to be prudent with our Q2 financial targets.

Adobe's mission of changing the world through digital experiences is more relevant than ever before. Moving forward, we will continue to focus on our three large growth opportunities: content offering, customer experience management and online marketing optimization.

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

Mike Saviage

Thanks, Shantanu. In regard to today's earnings report, we have posted several documents on our Investor Relations website today, including a copy of the script containing our prepared remarks for today's call. To access these documents and the other investor-related information, go to www.adobe.com/ADBE. We also encourage you to sign up for easy access to updated documents and communications via RSS feeds that you can subscribe to on the website.

For those who wish to listen to a playback of today's conference call, a web-based Adobe Connect archive of the call will be available from the IR Page at adobe.com later today. Alternatively, you can listen to a phone replay by calling (888) 203-1112. Use conference ID number 8900095. International callers should dial (719) 457-0820. The phone playback service will be available beginning at 4:00 p.m. Pacific time today and ending at 4:00 p.m. Pacific time on Friday, March 25, 2011.

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

Question-and-Answer Session

Operator

Certainly. Our first question from the phones will come from Walter Pritchard from Citi.

Walter Pritchard - Citigroup Inc

I was wondering if you could just talk a bit about the year and I think you had before talked about 10% growth for the year. Recognizing that you're making some changes here in Q2 around Japan, just wondering how that impacts what your outlook is for 2011.

Mark Garrett

Yes, hi, Walter. It's Mark. So actually, let me start with maybe a little bit of color on the rest of this year, and then I'll address your 10% question specifically. If you remember, back in December, we said if you looked through the rest of the year that we would have a slight revenue increase in the second quarter, that we would see a normal seasonal decline in the third quarter, and then we'd see seasonal strength and a sequential growth in the fourth quarter, and that OpEx would grow during the year, so as a result, margins would be slightly down in Q2, down again in Q3 and up in Q4. That's what we originally said back in December. That was, of course, prior to the Japan tragedy, and prior to what happened in Japan, we were on track to deliver against that guidance. There's kind of two scenarios now that I would paint for you. One is if Japan's Q2 is really impacted by the $50 million and then begins to recover, most likely, Q3 would now be up sequentially and then seasonal strength would bring sequential growth again in the fourth quarter, margins would grow sequentially in Q3 and again in Q4. That's one scenario. The second would be if the impact of the situation in Japan is, in Q2, much less than the $50 million, then our original quarter color is more likely to pan out. We continue to believe in our growth opportunities, we're taking prudent expense actions, but nothing drastic on the operating expense side, but until we see Japan improve, we do plan to keep operating expense relatively flat from Q2 to Q3. There'll probably be a seasonal uptick to OpEx in the fourth quarter, primarily in sales and marketing. So if you look at all of that as it relates to your question over the 10%, back in December, we did anticipate 10% revenue growth. But honestly, until we learn more about the true impact of Japan, it's just not prudent to comment on longer-term targets right now.

Walter Pritchard - Citigroup Inc

And then just a follow-up on the backlog number, I know that number does move around quite a bit from quarter-to-quarter. Could you just comment, Mark, on the decline you saw here from November into February. And I know there has been quarters where you've seen it actually increase there. I'm just wondering sort of what the driver was of that on quarter-to-quarter?

Mark Garrett

Sure thing. You're right, it does fluctuate quite a bit. If you net out Q1, as both Shantanu and I, I think, said in our prepared remarks, we're very pleased with our Q1 performance in terms of revenue, margin and earnings per share. And as you know, we always factor in the backlog when we give you our guidance. So it's already been factored in. If you look at the first quarter CS, Acrobat and Omniture all performed really well in the first quarter. The Enterprise value proposition is really resonating with customers. And we did see some large deals, as I said, push into the second quarter in the Enterprise space. Day was factored into our Q1 targets. It's now an integral part of that CEM Solution, and it's a large reason why we believe we can continue to grow this business 20%. If some of those deals didn't push into the second quarter, we probably would've been, frankly, towards the higher end of our range as opposed to over -- slightly over the middle of the range. And like I said as well, the Q2 pipeline for Enterprise is very strong. So if you net it out, we're happy with the quarter. Yes, we ended the quarter with no backlog, but, again, that's factored into the guidance.

Operator

We'll now go to Brent Thill from UBS.

Brent Thill - UBS Investment Bank

Mark, just a follow-up on Japan. I guess, how did you get to the $50 million? Is that just what you're starting to see like come into your pipeline? Or is there some scientific method behind this that you got to that number? I'm just curious in terms of how you're driving that. And then, I guess, when you talk about handicapping the back half of the year, how are you thinking about that right now?

Mark Garrett

Yes, so let me give you a little perspective about Japan. Our office is in Tokyo, we didn't have any real significant damage to the office itself. As Shantanu said, the most important thing is we've accounted for all the employees. We have roughly 300 people in the Tokyo office, in virtually every function, but primarily sales and marketing with some R&D folks. We don't have any manufacturing operations in Japan as it relates to creating the shrink wrap. We have asked our employees to work from home for now, given the rolling blackouts and the difficulties with transportation. If you look at our first quarter for Japan, it was seasonally strong, just as we had expected. And Brent, if you look at it, March, which falls in our Q2, it is the largest month of the year for us in Japan. And the first week of Q2, prior to the earthquake, was really strong, so we got off to a great start in the second quarter, as we expected. But there is no doubt that the pace of the revenue has changed since the earthquake. So what we're looking at in detail, and we've spent quite a bit of time on this, frankly, is weekly sell-through data for the first few weeks of the quarter, sales on Adobe.com for the first few weeks of the quarter, our Enterprise sales pipeline, and when we factor all that together and look at what we've seen so far, we come up with a $50 million negative impact, or roughly 30% of our Q2 revenue. And that's all we can do, frankly, at this point in time. In terms of how that starts to improve and the pace of that improvement over Q2, Q3, Q4, it's honestly too early to say. But obviously, when we get through the quarter, we'll tell you exactly how we did in Japan and be very transparent about how that played out relative to this $50 million.

Brent Thill - UBS Investment Bank

And just a quick follow-up on deferring your year-over-year growth, which is fairly strong, was there anything in deferred that was one-time of nature or anything that you should consider there?

Mark Garrett

No. I think what you're seeing in deferred, and you're going to, I think, continue to see this in deferred, is just continued growth as the hosted application businesses like Omniture continue to grow. That was the biggest driver in deferred and, obviously, that's a significant asset to that business.

Operator

We'll now go to Kash Rangan from Merrill Lynch.

Kash Rangan - BofA Merrill Lynch

Not to dwell upon Japan too much, but Mark and Shantanu, can you give us some color on which particular products, I know that you have a pretty diversified business, but which particular products are facing the impact in Japan? Are some product categories faring better than the other? Just some more color there would be useful. And also secondly, any broader commentary on business outside of Japan, principally U.S. and Europe, and how you're seeing business can shape up incrementally relative to your expectations in your core businesses?

Shantanu Narayen

So Kash, why don't I take that one? I mean, as it relates to Japan, I would say the predominant part of our business in Japan is the Creative and the Acrobat business. And so when we factor in what's happening in Japan, the primary impact is to the Creative and the Acrobat business. The Enterprise business is smaller in Japan, which is why Mark in his prepared remarks said that we would actually expect the Enterprise revenue to grow sequentially quarter-over-quarter despite the impact in Japan. And with respect to the rest of the world, I mean, U.S. and Europe, as we look at our three growth opportunities, we continue to feel that the opportunity that we outlined in December still remains. So no issues at all that we've seen so far of the Japan impact outside Japan.

Operator

And Brad Zelnick from Macquarie has our next question.

Brad Zelnick - Macquarie Research

Shantanu, it's great to hear the traction with Digital Publishing Suite. You mentioned 150 titles are available. Some of the new use cases, like corporate and catalogs, sound intriguing. Can you give us a sense of how the revenue sharing model is panning out relative to expectations and what the pipeline looks like in terms of titles?

Shantanu Narayen

Sure. I think as it relates to the Digital Publishing Suite, the reason why we're excited is frankly, it enables us to deliver authoring content, authoring not just on the desktop the way we've been doing, but to actually extend that offering by also providing a hosted solution. Just for others as well on the call, the revenue model associated with the Digital Publishing Suite, we have two editions right now. We have an Enterprise Edition and we have a Professional Edition. And the Enterprise Edition fundamentally has a few more customization as well as enterprise-level features, including analytics, built in. For example, using the Omniture SiteCatalyst and the Professional editing edition is really more about the standardized mid-market. And as I said, again, we really think that the Publishing Suite is going to be used not just for newspapers and magazines, which is the first beachhead, but much like InDesign, we expect book publishers as well as professional material to start using the Digital Publishing Suite. The cost of the solution, currently, we charge a yearly platform fee. And then in addition to that, there's a downloaded per-issue fee, which depends, frankly, on the publisher volume that exists. And in terms of the current beta testers, now that they've moved to the generally available version, our business model seems to be resonating with them, and the pipeline continues to be healthy. That is so early in the development. But as you see more tablets emerge, as you see every single publisher, whether it be an enterprise publisher, whether it be a government publisher or a media publisher, they will need a solution like the Digital Publishing Suite to get their content out to all of the different devices that exist. So I think they're very well-positioned. All of the titles, frankly, are still in the U.S., and when you start to think about how we get geographic expansion, there's a lot of opportunity up ahead for us.

Brad Zelnick - Macquarie Research

Just one quick follow-up on the mid-cycle CS5 release. When exactly does it ship? What exactly is it? And what are your expectations for adoption?

Shantanu Narayen

So a couple of things on that, Brad. I think we've been saying for a while that we are hearing from our customers that in order for us to enable them to deal with the multiscreen revolution that's happening, to deal with all of the multiple formats, we've been asked to provide more frequent releases. And as I said again, the mid-cycle release will start to focus on both integration of the Creative Suite with the Digital Publishing Suite. There'll be a fair amount of video production features that are going into that release as well as more capability, both for Flash and for HTML. I will say it sooner rather than later, but frankly, I'm not going to announce the product on this call right now. And the excitement around some of that functionality by the beta testers gives us room for optimism.

Operator

We'll now go to Steve Ashley with Robert W. Baird.

Steven Ashley - Robert W. Baird & Co. Incorporated

Hey, Mark, in terms of looking at the second quarter and the EBIT margin guidance you provided, is there any qualitative or quantitative comment you could make to say how those margins might have looked if Japan were normal?

Mark Garrett

So I think what I'd do, Steve, is go back to the guidance we gave you in December, which was that margins would have ticked down a little bit in the second quarter.

Steven Ashley - Robert W. Baird & Co. Incorporated

Great. And can you talk about large deals, whether -- and you can quantify that, kind of whatever you have or just maybe qualitative, quantitatively number of $1 million deals or $100,000 deals and what kind of trends you're seeing in that?

Shantanu Narayen

So Steve, maybe I'll also just add to your prior comment. I think as Mark said, in the short run, we've taken some prudent stab at expenses, but another way of modeling what the margin might have looked like is to take that $50 million impact and then add it to the top line. And that would've had, as you can clearly see, a significant uplift in the operating margin. With respect to the deals itself, the deals greater than $100,000, actually in the quarter that just completed in Q1, they grew fairly significantly, both over Q4 '10 as well as on a year-over-year basis over Q1. And we didn't put it in the data sheet more because we are more and more providing such a comprehensive offering, both in Creative and Acrobat as well as in the Omniture and Content Experience Management Solutions that, that number, frankly, is less relevant right now, because the revenue reflects the progress that we're making. But on a year-over-year basis as well as on a quarter-over-quarter basis, there was fairly significant improvement in those deals.

Steven Ashley - Robert W. Baird & Co. Incorporated

And with respect to the mid-cycle release, is that going to impact the timing of CS6?

Shantanu Narayen

Well, I think the way you can look at that, Steve, is the real goal for the mid-cycle release are -- continue to enhance the functionality, as I mentioned. We have talked about our desire to introduce subscriptions worldwide, which enables us to target the more price-sensitive customers. This would be in addition to the standard models that we have. We do not expect the mid-cycle release to cause a big shift in how people buy software. It will continue to be predominantly the shrink-wrap and the Licensing, and I think we'll see a nice supplement through the subscription model. And then you can expect another release in 2012.

Operator

And we'll now go to Ross MacMillan with Jefferies.

Ross MacMillan - Jefferies & Company, Inc.

Mark. I just have a little follow-up on -- I guess on the -- almost like bookings number if I adjust for the sequential decline in backlog. It sounds like you've gone through your pipeline in some debt, that sounded to me at least that Enterprise could be an area of incremental strength in Q2. And also a bit curious, should we expect some incremental benefit from the mid-cycle CS release as well? Are those two factors playing into your thoughts around the current quarter guidance?

Mark Garrett

So Ross, for Q2, yes, we do expect sequential strength in Enterprise, and we would expect Omniture to be up sequentially as well. Since we didn't talk about a release date specifically, I can't really comment on what the mid-cycle release would do from a CS revenue as it relates to timing, at least not yet.

Ross MacMillan - Jefferies & Company, Inc.

Did you say what you thought CS revenue would do sequentially?

Mark Garrett

We said that, other than Omniture and the Enterprise increasing sequentially, everything else would be flat to slightly down.

Shantanu Narayen

Because of Japan.

Mark Garrett

Because of Japan, yes. I mean you have to remember that, as Shantanu said, Japan is predominately CS and Acrobat, so those would likely go down with the $50 million drop.

Operator

Our next question will come from Michael Olson with Piper Jaffray.

Michael Olson - Piper Jaffray Companies

As far as the just general push towards subscription, any additional information you can give on kind of timing of when that becomes a more broad initiative, and then kind of success in the early markets that you've been pushing it in?

Shantanu Narayen

Sure. So Mike, again, the subscription would really be a new offering from Adobe on a worldwide basis. And the goal there is to allow new customers to use the Creative products sort of on a pay-as-you-go basis. And what we found in the early reports is that it's really valued by customers who seek flexibility and affordability of the monthly payments, and it attracts new customers who otherwise would not buy. We do think it's an opportunity to, frankly, target customers who haven't stayed current with CS4 or CS5. And all of those get factored into the revenue targets that we actually give out. And so that's the way I would look at subscriptions. In addition to that, clearly, we will continue as we get a regular cadence for the Creative products to also continue to offer both maintenance or upgrade plans, and that allows licensing customers to also stay current.

Ross MacMillan - Jefferies & Company, Inc.

And then just to confirm, you said the next release after the mid-cycle release will be in 2012. Is that correct?

Shantanu Narayen

That's correct.

Operator

And we'll now go to Adam Holt with Morgan Stanley.

Adam Holt - Morgan Stanley

I just had a couple of follow-ups about the large-deal environment and the Enterprise business in general. If you look at the larger deals in the quarter, are you starting to see more bundling cross-product? Or are they principally driven by larger single-product deals? And then, I guess, were there any common denominators around the deals in the Enterprise business that slipped?

Shantanu Narayen

So Adam, certainly, there are some customers for whom we do Enterprise licensing agreements across the spectrum of Adobe products. And so people who are using Creative Suite and Acrobat on the desktop and then, in conjunction with that, are buying Omniture as well as buying the Customer Experience Management Solutions and with Day. But to really answer the question more specifically, as it relates to Omniture, 2010 was a record bookings year. We continued to see good strength in the Omniture business, and we would expect to see 2011 also continue to grow bookings the 20% that we've talked to you about. As it relates to the customer experience management, what we did very successfully in Q1 was, frankly, to start to position the entire offering integrating Day. And as I said, we've actually already released a version of Day Software that allows you to have Omniture analytics, and we'll be enabling people who use Creative Suite to tie into that content management offering. And so it really was re-branding all of those new products. The Enterprise pipeline has been healthy. If anything, I would say, there was a little bit of push in the government in the U.S., but otherwise, we've seen strength across the world.

Adam Holt - Morgan Stanley

And if I could just ask a quick follow-up on the Acrobat business, which had another good quarter. And, Mark, I believe you called out in your comments the ability to raise price as a driver. Was there anything else that surprised you to the upside in the Acrobat business? Or was it primarily your ability to extract better pricing?

Mark Garrett

It was a combination, Adam, of units, continued expansion into that market and price. It was both.

Operator

Our next question will come from Heather Bellini from ISI Group.

Ryan Lee

This is Ryan Lee for Heather. Just wanted to ask you about the margin. You really outperformed on the margin line this quarter. I was wondering if you could walk us through where the upside came from and, particularly, if you can comment on how the ramping about these other businesses that are more enterprise-focused will impact your hiring plans as the year goes on?

Mark Garrett

So you've seen on the hiring that we've added a fair number of people in the first quarter. We added people in the beginning here of the second quarter as well. And you're going to see that the hiring has continued to be primarily in the sales and marketing area to drive sales capacity for that Enterprise business. So that's where we continue to invest as it relates to headcount. In terms of margin in the first quarter, we just have done, I think, a good job of managing the cost structure of the company. And revenue came in strong, as we said. And the combination of good cost management and good performance on revenue is what's driving that margin.

Operator

We'll now go to David Hilal from FBR Capital Markets.

David Hilal - FBR Capital Markets & Co.

First question is a clarification. I remember a mid-cycle release between CS2 and CS3. Have there been other meaningful mid-cycle releases since then, or is this going to be the first time since that point?

Shantanu Narayen

No. I think traditionally, we've added Acrobat because Acrobat is on a different product cycle than Creative, because Acrobat is also used a lot by the Creative community in terms of updating the releases. But for the most part, I would say that this is really a new strategy and given all of the functionality that we're putting in with respect to multiple screen as well as Digital Publishing Solution. We also did things like bundled the Macromedia products when we acquired Macromedia, but I would say this is really the first significant mid-cycle release.

David Hilal - FBR Capital Markets & Co.

And then shifting over to Omniture, I believe, say, Catalyst 15 was coming out this quarter. I guess is that on track? And can you talk a little bit about the upgrade process and what this new release means for your CapEx efficiency?

Shantanu Narayen

Sure. As it relates to Omniture, I do want to reiterate, we had a very, very successful Omniture Marketing summit that we had. And just the interest as it relates to the entire Adobe Online Marketing Suite, it continues to grow. The real impetus for releasing a new version of the core platform is to, frankly, enable it to continue to be efficient and to start to address the issues as it relates to social, video, as well as mobile. I mean, the amount of mobile growth that we're seeing through SiteCatalyst exceeds the growth that we're seeing, clearly, on PCs. And so the upgrade process for most customers is fairly transparent. As you can imagine, as a SaaS-based business, we moved them from one version of the product or platform to another version of the product. And so our new customers will start to move onto the new platform. We'll start to see the efficiencies associated with it. But, frankly, within the context of Adobe and from a CapEx point of view, all of that is factored into the target that Mark gives. So we're focused on continuing to drive efficiencies on the hardware side, but I think it's less of an issue than it was for Omniture as a stand-alone company.

Operator

We'll now go to Phil Winslow with Crédit Suisse.

Philip Winslow - Crédit Suisse AG

I just want to dig into the mid-cycle release of the Creative Suite here. As we've mentioned in the past, you had a mid-cycle release after 2, that was following at least some initial integration from Macromedia. Then, obviously, CS3 came out. That was a 24-month cycle between 2 and 3, obviously with -- I believe it's 2, 3 in between. How should we think kind of going forward here with your recent commentary over the past couple of quarters of more incremental sort of updates and releases to Creative Suite? I mean, should we think of 24-month cycles now, with 12-month, call it, interim releases? I mean is that kind of the cycle we should start thinking about going forward, especially with some of your commentary about subscription?

Shantanu Narayen

Yes, Phil, I think, order of magnitude, that's a good way to think of it. I mean, we want to continue to deliver value to our customers and to keep them on the current releases. And I think we've talked about the amount of fundamental innovation that continues to go in, a 24-month cycle is a good time frame for us to update most of the customers. But there's significant value that we can continue to provide on an annual basis, and that really is our goal.

Operator

And we'll now go to Chad Bartley with Pacific Crest.

Chad Bartley - Pacific Crest Securities, Inc.

Question for Mark, I don't think you addressed margins for full year. I just wanted to get an update. Your previous guidance, so it's for slight margin expansion relative to 2010 levels. Is that still the target despite what's going on with the revenue in Japan?

Mark Garrett

Again, it's hard for me at this point to give you an annual target until we truly see what the impact of Japan is. So we're not prepared today to discuss full-year targets for revenue or for margin. I think we've proven that we can manage the margin and cost structure of the company fairly well. So we'll, obviously, react to revenue. To the extent that we do see this impact and to the extent that revenue starts to improve in Japan, you'll start to see margin improved.

Shantanu Narayen

And Chad, I would say Mark and I have had a lot of discussions with the entire executive team. When you think about the three growth areas that we outlined, we continue to be really excited about the long-term growth opportunities. And we're not going to do anything that, in the short run, that impacts those long-term growth opportunities. I think we've already demonstrated that we are going to be prudent with Q2 expenses so that we can keep track of what's going on in Japan. But I would not take our comments in any way as a reflection of any reduced optimism in our growth opportunities moving forward.

Mike Saviage

We'll next take a question from the Connect Session. The question is, outside of the Omniture recurring growth, what are the other components of Adobe's business that are driving recurring revenue in fiscal 2011?

Mark Garrett

So outside of Omniture, the Connect business has a recurring piece of revenue. Scene 7 has a recurring piece of revenue. Obviously, as we add subscription-type services with the next release on the Creative side, that will have a recurring piece of revenue. So we continue to try to add to that base of recurring revenue, which today, if you add it all up, is approaching 20%. And clearly, we want that to continue to increase without taking away from the current license revenue.

Mike Saviage

And Operator, we'll take one more question, please.

Operator

And that final question today will come from Blair Abernethy from Stifel, Nicolaus.

Blair Abernethy - Stifel, Nicolaus & Co., Inc.

I just want to drill in a little bit on the vertical side. Shantanu, can you just give us a sense of how the education market performed for you in the quarter?

Shantanu Narayen

Sure, Blair. The education market had a nice rebound. That continues to be an area of investment as well as opportunity for us across the world. And so we had a strong quarter in education.

Well, thank you again for joining us today. As Mark said, we were pleased with our Q1 performance as well as the upside that we delivered from an EPS and the margin. And as a company, we continue to remain focused on the three growth opportunities that we outlined. Thank you.

Mike Saviage

This concludes our call. Thank you for joining us today.

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