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Adobe Systems Incorporated (NASDAQ:ADBE)

F2Q07 Earnings Call

June 14, 2007 5:00 pm ET

Executives

Mike Saviage - Investor Relations

Bruce Chizen - Chief Executive Officer

Mark S. Garrett - Chief Financial Officer, Executive Vice President

Shantanu Narayen - President, Chief Operating Officer

Analysts

Brent Thill - Citigroup

Jay Vleeschhouwer - Merrill Lynch

Sasa Zorovic - Goldman Sachs

Heather Bellini - UBS

Adam Holt - J.P. Morgan

Jason Maynard - Credit Suisse

Ross MacMillan - Jeffries & Company

Peter C. Kuper - Morgan Stanley

Steven Ashley - Robert W. Baird

Eugene Munster - Piper Jaffray

Trip Chowdhry - Global Equity Research

Christopher Rowen - Soleil Securities

Daniel Cummins - Bank of America

Robert Breza - RBC Capital Markets

Presentation

Operator

Good day, everyone. Welcome to the Adobe second quarter fiscal year 2007 earnings conference call. Today’s call is being recorded. At this time, I would like to turn the call over to Mr. 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 Bruce Chizen, our CEO; Shantanu Narayen, President and COO; and Mark Garrett, Executive Vice President and CFO. In the call today, we’ll discuss Adobe's second quarter fiscal year 2007 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, you can go to adobe.com under the company and press links to find it.

Before we get started, I want to emphasize that some of the information discussed in this call, particularly our revenue and operating level targets and our forward-looking product plans is based on information as of today, June 14, 2007 and contains forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements.

For a discussion of these risks and uncertainties, you should review Adobe's SEC filings, including our annual report on Form 10-K for fiscal year 2006 and our quarterly report on Form 10-Q in fiscal year 2007.

During this call, we’ll discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings release and on our investor relations 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 playback purposes. An archive of the call will be made available in Acrobat Connect 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.

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Bruce Chizen

Thanks, Mike. I’m pleased to report that Adobe achieved record revenue in our second quarter of fiscal 2007. Revenue was $745.6 million, which exceeded our target range and represents 17% growth over the same quarter a year ago. Non-GAAP diluted earnings per share were $0.37, which also exceeded the high-end of our targeted range. Driving our results was the strong performance of our Creative Suite products and the continued momentum of our Acrobat product family, both of which achieved record revenue.

We also continued to drive adoption of our enterprise solutions, which once again achieved sequential and year-over-year growth. In a few minutes, Shantanu will provide additional business highlights for the quarter, but first I’ll turn it over to Mark for a review of our financial results. Mark.

Mark S. Garrett

Thank you, Bruce. For the second quarter of fiscal 2007, Adobe achieved record revenue of $745.6 million. This compares to $635.5 million reported for the second quarter of fiscal 2006 and $649.4 million reported last quarter.

GAAP operating expenses for the second quarter of fiscal 2007 were $474 million compared to $430.8 million last quarter. Non-GAAP operating expenses were $417 million, compared to $382.4 million last quarter.

GAAP operating income in the second quarter of fiscal 2007 was $180.4 million, or 24.2% of revenue. This compares to GAAP operating income of $147.9 million, or 23.3% of revenue in the second quarter of fiscal 2006 and $146.3 million, or 22.5% of revenue last quarter.

Non-GAAP operating income in the second quarter of fiscal 2007 was $282.1 million, or 37.8% of revenue. This compares to non-GAAP operating income of $243.1 million, or 38.3% of revenue in the second quarter of fiscal 2006 and $223.8 million, or 34.5% of revenue last quarter.

Adobe's GAAP effective tax rate for the second quarter of fiscal 2007 was 25.6%, and Adobe's non-GAAP effective tax rate was 26.2%.

GAAP net income for the second quarter of fiscal 2007 was $152.5 million compared to $123.1 million reported in the second quarter of fiscal 2006 and $143.9 million last quarter.

Non-GAAP net income was $223.2 million compared to $189.4 million reported in the second quarter of fiscal 2006 and $183.6 million last quarter.

GAAP diluted earnings per share for the second quarter of fiscal 2007 were $0.25 based on 603.4 million weighted average shares. This compares with GAAP diluted earnings per share of $0.20 reported in the second quarter of fiscal 2006 based on 613.8 million weighted average shares and GAAP diluted earnings per share of $0.24 reported last quarter based on 604.2 million weighted average shares.

Non-GAAP diluted earnings per share for the second quarter of fiscal 2007 were $0.37. This compares with non-GAAP diluted earnings per share of $0.31 in the second quarter of fiscal 2006 and $0.30 reported last quarter.

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

Creative Solutions segment revenue was $436.6 million, compared to $360.1 million in Q2 of fiscal 2006 and $346.4 million last quarter.

Knowledge Worker segment revenue was $184.8 million, compared to $160.1 million in Q2 of fiscal 2006 and $174.8 million last quarter.

Enterprise and Developer segment revenue was $52.3 million, compared to $42.9 million in Q2 of fiscal 2006 and $50.9 million last quarter.

Mobile and Device segment revenue was $12.3 million, compared to $7.7 million in Q2 of fiscal 2006 and $13.7 million last quarter.

Finally, our Other segment revenue was $59.6 million compared to $64.7 million in Q2 of fiscal 2006 and $63.6 million last quarter. This decline was due to lower revenue from some of our legacy products in our print and classic publishing business.

Geographic results in Q2 fiscal 2007 on a percent of revenue basis were as follows: the Americas, 52%; Europe, 28%; Asia, 20%. We experienced exceptionally strong demand in North America, driven by the English launch of our Creative Suite products.

Regular employees at the end of the second quarter totaled 6,427 versus 6,151 at the end of the first quarter of fiscal 2007. The majority of the headcount increase from last quarter was in research and development.

Our trade DSO in the second quarter of fiscal 2007 was 39 days. This compares to 40 days in Q2 fiscal 2006 and 43 days last quarter.

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

During the quarter, we repurchased 5.9 million shares at a cost of $232.4 million as part of our share repurchase programs. At the end of the second quarter of fiscal 2007, cash and short-term investments were $2.3 billion, essentially the same as the end of last quarter.

This concludes my discussion on our financial results. I would now like to comment on our targets for our third quarter of fiscal 2007. Our targets factor in typical Q3 seasonal weakness.

We are targeting a revenue range of approximately $760 million to $800 million. In addition, we are targeting a GAAP operating margin of 27% to 28% and a non-GAAP operating margin of approximately 39%. We are targeting our share count to be approximately 607 million to 609 million shares. For other income, we are targeting approximately $21 million to $22 million. For our GAAP effective tax rate, we are targeting approximately 25% to 26%, and on a non-GAAP effective tax rate of approximately 26% to 27%.

These targets lead to a GAAP earnings per share range of $0.28 to $0.31 per share and a non-GAAP earnings per share range of $0.39 to $0.41.

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

Shantanu Narayen

Thanks, Mark. I’ll spend the next few minutes reviewing highlights from our performance in Q2, starting first with the Creative Solutions business.

Our Creative Suite 3 family of products began shipping in April in English. Bulk shipments of the French and German versions began shipping in early Q3. The Japanese version and other localized versions will be shipping throughout this summer. The new video products and the Master Collection Suite are expected to ship later this quarter.

Industry response to the new Creative Suite products has been tremendous. PC Magazine just awarded Creative Suite 3 an Editor’s Choice Award, stating “With six different editions of the Adobe Creative Suite 3, there’s bound to be a collection that will meet the needs of any computer graphics artist.”

Individual point products have received strong reviews as well. Illustrator received a 5 out of 5 rating from PC Magazine. InDesign earned a 4.5 out of 5 rating in MacWorld Online. Flash Professional received an Excellent rating and Editor’s Choice Award from ZNet, and Dreamweaver garnered a 3.5 out of 4 rating in CreativePro.com.

The positive reviews and anticipation for the new version helped drive record revenue for our creative business.

Based on the CS3 results in Q2, we can make the following statements: as expected, the best-selling Creative Suite thus far has been the design suites. The premium versions of the design and web creative suites are outselling their standard counterparts. Version over version, we have experienced a 30% increase in revenue with our CS3 family of products for the same comparable CS2 time period. We’ve seen strong demand for Macintosh versions of the software which support the new Intel architecture.

We caution everyone that it is early in the CS3 launch and it is premature to draw long-term conclusions from these initial results.

In our digital imaging business, we delivered two versions of Photoshop CS3, Standard and Extended, to positive reviews. MacLife gave it a perfect 5 out of 5 “Awesome” rating and an Editor’s Choice Award. PC Magazine gave both Photoshop CS3 Standard and Extended the Editor’s Choice Award, saying that “Photoshop remains the best option for getting anything done in the field of computer graphics.”

Customer interest and adoption of our dynamic media solutions continues to be strong. For example, the BBC selected CS Production Premium as its preferred solution for PC-based non-linear editing and post-production.

We recently previewed the new Adobe Media Player, which enables new ways for content publishers to distribute and monetize media. Adobe Media Player enables better ways to deliver, track and protect video content. It also enables a wider selection of monetization and branding options, including viewer-centric dynamic advertising and the ability to customize the look and feel of the player on the fly to match the brand or theme of the content.

Finally, in early May we announced our acquisition of Scene 7, a technology innovator in real-time rich media delivery services. Leading online retailers like Macy’s, Levi Strauss, Land’s End, and QVC have selected Scene 7 to automate the production and availability of rich media web experiences. We plan to expand Scene 7’s interactive publishing services as we extend the online presence of our flagship Creative technologies.

In our Knowledge Worker solutions business, Acrobat achieved record revenue in Q2. Driving this performance was volume licensing, which accounted for more than 60% of overall Acrobat revenue. In addition, Acrobat Professional revenue continues to outpace Acrobat Standard revenue, reflecting demand for advanced collaboration and security capabilities.

Last week, we announced the availability of Acrobat 3D Version 8, a major upgrade for driving document-based 3D design collaboration. Engineering Automation Report called it “A game changer in its ability to import and export 3D CAD data in a variety of formats.”

In March, we released guidelines with MISMO, a not-for-profit subsidiary of the Mortgage Bankers Association, for the standardization of electronically signed PDF documents in the mortgage process. The guidelines are intended to help standardize the implementation of PDF and electronically signed PDF documents across the mortgage banking industry.

Looking to next quarter, we expect Knowledge Worker revenue to be lower sequentially due to typical seasonal weakness.

In our Enterprise and Developer Solutions business, last week we introduced Adobe Lifecycle Enterprise Suite, an integrated family of software for automating processes that help businesses and governments more effectively engage with customers, citizens, partners and suppliers.

Lifecycle ES integrates the capabilities of PDF and Flex technologies while leveraging the reach of Flash Player and Adobe Reader to enable a new class of customer engagement applications that easily connect people inside and outside organizations to internal information and processes.

We continue to drive Lifecycle customer adoption and achieve sequential and year-over-year growth. Q2 wins included the U.S. Department of Defense’s Form Management Program, which has licensed Acrobat Professional and Lifecycle to automate processes and streamline operations by providing fillable forms to all DOD entities, including the Army, Navy, Air Force, Marines, Coast Guard and Joint Chiefs of Staff, as well as the Office of the Secretary of Defense and defense agencies; the Portuguese Ministry of Agriculture, which is using an Adobe form solution to move farmer funding and subsidy processes from manual to electronic forms as part of Portugal’s e-government strategy to reduce costs while increasing efficiency; and Aloha Airlines, which has adopted an Adobe form solution to automate internal processes such as HR, purchasing and other administrative and traditionally manual processes, reducing the inefficiencies and costs associated with paper while addressing the need for SOX compliance.

In total, the number of enterprise transactions in the quarter with licensing revenue greater than $50,000 for server products, including Lifecycle, Flex, Acrobat Connect and Flash Media Server, was 101.

In our Mobile and Device Solutions business, we continue to make progress with mobile operators worldwide and we’re seeing continued demand for great interactive mobile experiences, including web browsing. We announced that Verizon and Chunghwa Telecom of Taiwan expect to deliver Adobe Flash Cast services to their subscribers before the end of 2007.

We also delivered Flash Lite 3.0 and Adobe Reader LE 2.5 to our OEM and operator partners. Flash Lite 3.0 is the latest Flash player for mobile and devices, bringing Flash video and Flash 8 web browsing support and performance improvements over prior releases, while supporting a wide range of mobile phones and consumer electronic devices.

In our platform business, this week we announced the public beta of Adobe Flex 3 software, the cross-platform free open-source framework for creating rich Internet applications. This major functional release adds rich new user interface capabilities, enhanced developer productivity, desktop deployment and enterprise testing and performance tools.

The Flex 3 public beta also marks the first significant deliverable for the open-source Flex project which we announced in late April as an initiative to let developers worldwide participate in the growth of the Flex framework.

We also announced the beta version of Adobe Integrated Run-time, or Adobe AIR, formerly code-named Apollo. Adobe AIR is a cross platform system application run-time that allows developers to use HTML, AJAX, and Adobe Flash and Flex to extend rich Internet applications to the desktop.

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

Bruce Chizen

Thanks, Shantanu. At our financial analysts meeting a few months ago, we provided an overview of market trends that are fueling multiple growth opportunities for Adobe. We reviewed our strategies in these markets and we highlighted our long-term goals for delivering solutions which revolutionize how the world engages with ideas and information.

Our results in the first-half of fiscal 2007 demonstrate we are executing well against our strategy. Already this year, we’ve delivered the much-anticipated CS3 family of products. As you’ve heard today, CS3 is off to a great start, with outstanding reviews and strong early adoption by our customers.

In addition, we continue to drive momentum in our Knowledge Worker and Enterprise businesses. Acrobat achieved record revenue and we just delivered Lifecycle ES, our first integrated enterprise solution combining PDF and Flash technologies. The opportunities continue to be significant for both product families and we are investing for long-term growth in these as well as other areas, including web conferencing and mobile solutions, leveraging our Flash ecosystem.

Finally, this week we announced the beta release of Adobe Integrated Run-time. In the same way that Adobe technology contributed to the desktop publishing revolution, we believe Adobe Integrated Run-time is going to revolutionize today’s web experience. It will enable a whole new category of rich Internet applications that harness the power and resources of the web but without the constraints and limitations inherent in web browsers.

As revolutionary as this will be for end users, we see it as an evolutionary step for developers as it leverages all the same open and industry standard technologies they use today, including PDF, AJAX, HTML, and Flash.

Based on our year-to-date results, and assuming continued business momentum, we expect to exceed our original fiscal year revenue and profit targets. It’s an exciting time for Adobe and we look forward to sharing our success with you as we move through the rest of the year. Mike.

Mike Saviage

Thanks, Bruce. Before we start Q&A, a couple of logistical items. We have set the date for MAX 2007, our annual customer and developer conference. It will be held in Chicago September 30th through October 3rd. Information about MAX can be found online at www.adobemax2007.com.

As always, we have posted several documents on the IR page of Adobe.com related to our earnings report today. They include today’s earnings release, our updated investor datasheet, 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 www.adobe.com/adbe.

For those who wish to listen to a playback of today’s conference call, a web-based Acrobat Connect archive of the call will be available from the IR page on Adobe.com later today. Alternatively, you can listen to a phone replay by calling 888-203-1112. Use conference ID number 5300438. Again, the phone number is 888-203-1112, with ID number 5300438. 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 Monday, June 18, 2007.

We would now be happy to take your questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll go to Brent Thill with Citigroup.

Brent Thill - Citigroup

Thanks. Good afternoon. I was wondering if you could just help us understand your assumptions into the international launch of CS3. If we go back to CS1, I think between the U.S. and international launch you had a $65 million sequential improvement in revenue and it looks like you’re calling for a $35 million to $55 million sequential improvement into the next quarter. It seems a slightly more conservative approach into this cycle.

Bruce Chizen

There’s one thing you want to factor in is that it’s a particularly tough period for us in Europe because of the seasonality, so you have to factor that into those assumptions, as we did. Clearly how we do in the last few weeks of August as Europe gets back to work will determine to some degree whether we come at the high-end or closer to the lower end of the range.

Brent Thill - Citigroup

Okay, and a follow-up for Mark real quickly; on Other revenue, it looks like this is the lowest quarter in the last four. Can you just speak to what’s going on in the Other segment?

Mark S. Garrett

Hang on one sec, Brent. Other revenue, I’m sorry. I thought you said other income. On the Other revenue line, that’s the platform business and that’s been sequentially down due to the legacy product. So if you look at it, a piece of that business is composed of products like Pagemaker and Freehand and GoLive. Those are products that are obviously being somewhat replaced by some of the newer offerings in the Creative Suite.

Brent Thill - Citigroup

Thanks.

Operator

We’ll go next to Jay Vleeschhouwer with Merrill Lynch.

Jay Vleeschhouwer - Merrill Lynch

Thanks. Good afternoon. Bruce, as you had foreseen at the analyst meeting, the Design Suite is thus far the best-selling version of CS3. Could you foresee however that another flavor, perhaps Web or Master Collection or Production when they all become available could at some point surpass the contribution from design collection? Or would you expect it to remain the largest indefinitely?

Secondly, a longer term question since you brought up the various growth drivers; even before CS3 launched the company had said that one of the things you would have to do well, particularly with all the segmentation coming, would be messaging and positioning the different flavors well in the Creative Solutions business, and by the same token managing Acrobat well both as a general purpose and vertical market product, two different aims for that product. Do you think that you’re doing all of that well in terms of finding exactly the right balance of resources and messaging, or do you think that certain adjustments ought to be made?

Shantanu Narayen

Let me take the first part of the question, which was about design collection versus the other suites. At the analyst conference, our projection was that what would do best was the design suites. Thus far in the cycle, and it’s early in the cycle, we have seen that come to pass. As you know, we haven’t shipped the master collection yet so it’s hard to tell how the master collection will do.

The customer feedback has been positive and we anticipated that the master collection and the web bundles would be neck-and-neck as the second after the design suites but it’s entirely possible that as people look at what’s in the master collection that that continues to grow. It’s just still a little early for us to tell. Clearly the premium version of the suites are also doing well, which is nice to see because the premium versions also have Photoshop Extended and we’re trying to make sure that people see the benefits of the Photoshop Extended.

We’re pleased so far with the feedback we’ve got on the messaging front. It seems like we’ve articulated the offerings well. Clearly that was played back in some of the reviews that we’ve seen in terms of our overall segmentation against the print customer, the design customer, the web customer, as well as the production customer for video and master collection. So on the messaging side, we’ve been pleased.

But again, I’d caution like I said in my prepared remarks; the results are really good so far but it’s very early in the cycle.

Bruce Chizen

I would just add we do have a healthy backlog going into the Q3 period for the foreign language products as well as some of the newer products, like master collection, which is also very encouraging.

As it relates to Acrobat, we continue to see Acrobat Pro slightly outselling standalone Acrobat, which leads us to believe that the customers are understanding the additional value that we have in the product and those in particular in vertical markets are procuring them.

Jay Vleeschhouwer - Merrill Lynch

Last question; you said that Acrobat had record revenue, up sequentially. Do you think that you’ve now put behind you the inertia that you had with Acrobat 7 and that you’re seeing better underlying momentum for 8 with 7 behind you now? Or if not, if the compulsion to move to 8 from 7 is let’s say relatively muted, might you run into the same situation with 9 later next year?

Shantanu Narayen

I think with Acrobat specifically, last quarter we had said that we had some licensing issues which contributed to the revenue being slightly less than we anticipated. We think and believe that those are all behind us. Acrobat 8 this quarter was clearly driven by licensing. We had record licensing revenue in the quarter. And the reality of the business is it’s actually mainly new unit business and new units that are driving Acrobat 8 revenue rather than a movement from 7 to 8 per se.

Bruce Chizen

And while we’re not prepared to go into any specifics on Q4, it is our belief, at least as of today, that we will see an up-tick in Acrobat revenue over Q3 as we move into a stronger seasonal period.

Jay Vleeschhouwer - Merrill Lynch

Thank you.

Operator

We’ll go next to Sasa Zorovic with Goldman Sachs.

Sasa Zorovic - Goldman Sachs

Thank you. First, let me ask you basically here a little bit of balance sheet related questions. We had deferred go up a fair bit quarter over quarter and also accrued expenses. Could you give us a bit of background as to why on both of these?

Mark S. Garrett

On the deferred side, the bulk of the deferred is made up of two pieces; one is Lightroom, which we book ratably due to the fact that we provide upgrades to the customer, and the second is the CS2 to CS3 upgrades that we defer until we ship CS3. So the two of those together are the bulk of the deferred revenue.

Bruce Chizen

And then obviously, as we ship CS3 in the foreign languages, we will reverse that out in Q3.

Mark S. Garrett

I’m sorry, what was the second question on the balance sheet?

Sasa Zorovic - Goldman Sachs

Accrued expenses.

Bruce Chizen

Can you repeat that, Sasa? We’re having --

Sasa Zorovic - Goldman Sachs

Yes, so accrued expenses went up a bit sequentially, so if you could give us a little bit of reasons as to why.

Mark S. Garrett

The bulk of that is due to marketing activity, so promotional activity.

Sasa Zorovic - Goldman Sachs

It’s a fair bit of an increase. Is it all due to marketing?

Mark S. Garrett

No, but let me look at it and I’ll get right back to you.

Sasa Zorovic - Goldman Sachs

Okay, and could you also tell us quickly any benefit from currency that you had in the quarter?

Mark S. Garrett

During the quarter, we had roughly net of $13 million of benefit on a year-over-year basis driven by the Euro, and on a quarter-over-quarter basis, roughly $2 million, also driven primarily by the Euro.

Bruce Chizen

One thing to keep in mind, Sasa, that when we provide targets or guidance at the beginning of the quarter, we already factor in any year-over-year currency gains or losses that have already transpired. So when we provided the original guidance of I believe it was 700 to 740, we already factored in the strong Euro and a small, I believe it was a small decrease in the Japanese Yen. The only benefit that we received since then was approximately a net of $2 million.

Sasa Zorovic - Goldman Sachs

I see. Great. Thank you very much.

Mark S. Garrett

Sorry, the other part of the accrued expenses has to do with the ESPP program, the employee stock program, purchase program.

Sasa Zorovic - Goldman Sachs

ESPP?

Mark S. Garrett

ESPP, yes.

Sasa Zorovic - Goldman Sachs

Great.

Operator

We’ll take our next question from Heather Bellini with UBS.

Heather Bellini - UBS

Bruce, I was wondering if you could talk a little bit about the CS3 Suite sales and as you think of them as a percentage of total units in the CS3 cycle, would you see them comprising a higher percentage than what you saw in the CS2 cycle? So are we going to see suites have a higher percentage of unit volume do you think versus the a la carte products?

And then I just had a follow-up to that, would be you had mentioned a couple of quarters ago that you would expect a significant up-tick in, I think you used the words significant up-tick in Creative Solutions in the August quarter on a sequential basis. I was just wondering if you’d be willing to say, would you expect a higher sequential growth rate for the Creative Solutions in the August or the November quarter? Thank you.

Shantanu Narayen

Let me take the first one with respect to what kind of mix we see for our Creative products moving forward. Certainly we do expect the suites to be a greater percentage of the overall revenue in the Creative business. We anticipated going into Q2 that we would see approximately 60% of the revenue from the suites as a total, suite service as the point products. The results actually were in line with our expectations, a little bit higher, actually, on the suite sales. So we’ve been pleased. Certainly as the master collection and the production suite also comes on board and we get a little bit more data, we’ll analyze that but it’s clearly in line with what the strategy is, which is to get our customers to adopt the entire platform.

Let’s also remember that with a number of the larger customers, what happens is they’ll be trying out a few of the products and a number of the larger customers also tend to standardize on the suites moving forward.

Heather Bellini - UBS

And what was the percentage --

Mark S. Garrett

And then sequentially, we would expect Creative to be up significantly from Q2 to Q3 as we ship foreign language versions and other aspects of the product later in the summer.

Bruce Chizen

And as it relates to Q4, we’re not going to be providing any color today, until we get through Q3.

Heather Bellini - UBS

Thank you.

Operator

We’ll go next to Adam Holt with J.P. Morgan.

Adam Holt - J.P. Morgan

Good afternoon. Thank you. I have two questions on the trajectory of the upgrade cycle. You said historically that this particular CS3 cycle or this particular CS cycle may have more staying power than some of the previous cycles. Based on what you’ve seen thus far, could you give your latest thoughts on what you would expect to see from the professional upgrade?

Secondly, how do you think master collection changes that trajectory?

Shantanu Narayen

I think the macro trends that we talked about prior to the release of the Creative Suite 3 launch still exist, namely the digital explosion that we’re seeing, the continued use of video on the web, as well as on mobile devices. The fact that the MacTel transition is happening and we’ve now provided support for the Mac platform/Vista adoption because in the past, hardware adoption does tend to drive software purchases. So all the macros, and it’s the first release of the product that combines the best of the former Macromedia products with the Adobe products.

Customer feedback has been really good. We believe all those macro trends are still in existence, which should all go well for the CS3 launch. It is still so early. I really want us to be careful about getting ahead of ourselves in terms of understanding how this is going to play out. And more specifically I think as it relates to the master collection, as Bruce mentioned earlier, we are seeing backlog for it. We do anticipate customers adopting the master collection and we’ll have more data after Q3.

Bruce Chizen

There’s nothing that we’ve seen changed in the marketplace that would change what we said two months ago at the analyst meeting. More people are trying to create more information than ever before. The fact that we exceeded the original targets is at least evidence to us that our beliefs were correct and we believe that the tail on CS3 should reflect or mirror that of what we saw with CS2 and CS1, in that in the latter quarters we should see that business improve and not decline.

Adam Holt - J.P. Morgan

If I could just ask a follow-up in a little bit of a different direction on the direct sales side, could you talk about the influence of direct selling on the Acrobat business this quarter? And maybe update us as to where you are on some of your investments in building out your direct force. Thanks.

Shantanu Narayen

I think when we look at the Acrobat revenue and specifically the Acrobat licensing revenue, a large part of that is influenced by our direct sales force. We have Matt Thompson on board and he has been really focused on two aspects of it, which is one, making sure that in conjunction with our licensing partners, we have the appropriate vehicles to get larger customers to adopt the Acrobat business, but in addition to that, making sure that we have a good inside sales presence as well.

So we’re pleased with what we are seeing. The enterprise business for Acrobat is certainly doing well. The licensing issues are behind us. We have a good team in place with Matt and a layer below him, and so that should continue to all go well for our Acrobat penetration within the enterprise.

Bruce Chizen

As it relates to the impact it has on our Lifecycle business, the fact that we had continued year-over-year growth and that we had sequential growth ahead of having a solution that is fully integrated with both Flash and PDF technologies is encouraging and also gives us validation that all of the changes that we’ve made over the last couple of years with our sales organization have been the right ones.

Adam Holt - J.P. Morgan

Thank you.

Operator

We’ll go next to Jason Maynard with Credit Suisse.

Jason Maynard - Credit Suisse

Good afternoon. I actually have two questions, one just sort of a follow-up on the out-performance that you had this quarter. What are the assumptions next quarter then and the full year around the percentage of suite sales and premium versions? Is it going to be roughly 60% for suites as you look at guidance for Q3 and then for the full year?

Shantanu Narayen

Our initial expectations were that the suites be about 60% of the revenue. Again, we need a little bit more data before we change that assumption. As I said, we’re tracking according to our original expectations.

Bruce Chizen

Keep in mind we’ve only been shipping the product for about six weeks. We haven’t shipped the master collection. We haven’t shipped the video products and we haven’t shipped, other than a tiny bit, we didn’t ship any of the foreign language products. For us to sit here and to draw conclusions, or to ask you to draw conclusions on that limited amount of data would not be very prudent of us.

We are ecstatic. We’re ecstatic that we exceeded the original revenue guidance. We’re ecstatic that we exceeded the original EPS guidance. We’re pleased with the customer adoption of the products. The reviews have been stellar -- in fact, better than any reviews we’ve historically seen with any of our CS3 offerings, including some of the standalone products’ standalone reviews.

With that said, we are entering a seasonally weak quarter. It’s why the range is what it is but given where everything is, we do expect to exceed the original fiscal year forecast. To give you more data on the nuances of each individual SKU and the suites would not give you the appropriate level of information to put your own models together, because it’s way premature.

Jason Maynard - Credit Suisse

Okay, that’s fair. Let me shift gears and ask you a question about Apollo and now AIR. How do you foresee this playing out and maybe any comments you can make around the potential synergy with Google Gears and if that is going to be a catalyst for increased adoption?

Shantanu Narayen

I think what we are excited about with respect to Apollo is the customer feedback and the developer feedback, which I think is important at this point in the evolution of -- the integrated run-time has been really positive. We were really pleased that we were able to get out the next version to our developers and we’re actually starting to see a number of applications that have been built that take advantage of this particular platform and demonstrate the obvious benefits of being able to combine the power of the web with the power of the desktop, you know, applications like ebay.

So it’s early on. Clearly the revenue model for us with Apollo is associated with the tools that we deliver, it’s associated with the Flex and Lifecycle data services that we will be able to do and the creative authoring applications.

Google Gears is complementary. I think again that demonstrates the need for offline database that allows people to do more with web-based applications, but the reality with even Google Gears is that it is still just in conjunction with a browser. What we have with Apollo allows you to have even a stronger set of applications.

So really good progress so far on Apollo and AIR.

Jason Maynard - Credit Suisse

Thank you.

Operator

We’ll go next to Ross MacMillan with Jeffries.

Ross MacMillan - Jeffries & Company

Thanks. I guess two questions, one just quick one; did you actually ship -- I think you said German and French. Did those products ship in the May quarter? I’m trying to understand whether there was inventory drain that crossed over last quarter to this quarter on those language versions that would have had a negative impact, if you will, on those products for the May quarter.

Shantanu Narayen

What I said was that the bulk of the French and German shipped early in Q3. What happens is typically we have the product go GM. There were a couple of licensing orders that we fulfilled at the end of Q2 and very, very small, and what we do is we manage the channel very effectively in terms of making sure that there isn’t old inventory in the channel. But really the bulk of French and German will be seen in Q3.

Ross MacMillan - Jeffries & Company

Great, and one follow-on; last year the fully diluted share count fell progressively through the year. You clearly have a lot of cash on hand, but it does look both from your guidance and where we were in Q1 that you are willing to let the fully diluted share count creep up. Can you just recap your strategy on that and whether, what you plan to do in terms of speed of buy-backs, and basically whether you’re willing to let that fully diluted share count go up this year? Thanks.

Mark S. Garrett

We repurchased 5.9 million shares. That’s up a million from what we did last quarter. As you know, we announced a program to repurchase up to 20 million shares of stock and we added $500 million to our existing program to offset dilution. And we intend to follow these new programs through the repurchase commitment of shares via financial institutions using structured programs, as we have in the past, and you can read about those in our SEC filings.

Our strategy is to balance the optimizing of cost of capital with the price of the repurchase, with tax efficiencies, and we have to do all of that within the confines of our blackout period. So we intend to move forward with these repurchase programs and you’ll see us do that.

Operator

We’ll take our next question from Peter Kuper with Morgan Stanley.

Peter C. Kuper - Morgan Stanley

Thanks very much. Bruce, I think you mentioned on the call a couple of times that you guys are above plan for the fiscal year on a number of levels. Could you give us a flavor -- is that like 10%, 15%, 20%, something in numbers obviously?

And then, as part of that, Acrobat forms, the online fillable solutions here with the Department of Defense and the mortgage company wins, et cetera, do we think we’re finally seeing better mass adoption now for people really migrating away from paper to a fully integrated online solution?

Mark S. Garrett

I’ll take the first part of that. As it relates to plan, like Bruce said, we’re really pleased with the quarter. We’re pleased with our progress so far but we can’t comment on how that relates to our internal plan.

Bruce Chizen

And as it relates to the fiscal year guidance, assuming our business momentum stays the same, meaning customer adoption of our products continues to be as positive as they are and the economy continues to do well in the markets in which we participate in, we believe that we’re going to exceed the original guidance that we announced in January as well as reconfirmed at our March analyst meeting.

In terms of the extent of that, it’s difficult to communicate at this point until we really understand how well we do in Q3. Clearly if we come in at the higher end of the range, we’ll exceed, Q4 will shape up to be a great quarter and we’ll exceed the original guidance by a significant amount.

Shantanu Narayen

On the forms side, Peter, we are certainly very pleased with what we are bringing to market with Lifecycle ES, because it brings together all the Lifecycle products into a single platform which will really enable ease of adoption and installation, but also frankly far more performing and interactive front-ends, which enable people to create a more engaging application with not just Reader and PDF but also the Flash player and Flex. So the products are doing well. The go-to-market, we’ve significantly enhanced the capabilities, whether it’s to our own direct sales force as well as the partner program has been maturing in conjunction with SAP, and we expect the revenue to be sequentially up in Q3.

However, having said that, our anticipation is not that we will see a hockey stick. We will continue to make progress. We have great customer references, which is why we try to demonstrate applicability across a wide variety of users in various different verticals.

Peter C. Kuper - Morgan Stanley

Thanks very much.

Operator

We’ll go next to Steven Ashley with Robert W. Baird.

Steven Ashley - Robert W. Baird

First of all, a point of clarification; Master Collection and Production Premium are going to ship late in the third quarter. Is that just the English language versions and when would you expect the foreign language versions of those products to ship?

Shantanu Narayen

We actually expect language versions also, the major language versions of the Master Collection and Production products to ship in Q3. We haven’t specified when in the quarter.

Bruce Chizen

However, as Shantanu did say in his prepared remarks, they are on schedule as planned. We just haven’t been specific on when that will be.

Steven Ashley - Robert W. Baird

Maybe you could just give us a comment on Flex builder 2 and how the adoption of that product is going?

Shantanu Narayen

We continue to see a fair amount of adoption of the Flex builder product. I think what we did with the open source movement as well with Flex has really got a good customer response. We came out with some, you know, the first real version of Flex which is in the open source. So the customer adoption is good.

We also brought out a Macintosh version of Flex builder to make sure that we have more cross-platform support and the fact that it actually builds on top of Eclipse is also in line with what our customers want us to do.

Bruce Chizen

One of the most telling indicators of the increasing popularity of Flex, the desire to do rich Internet applications, the desire to take advantage of Flash, and then in the future Apollo or the Adobe Integrated Run-time, is the -- O’Reilly introduced a book on Flex and according to them, it was the most popular computer book that they offered since the first Java book that they introduced five years ago. So that was pretty encouraging to us here at Adobe.

Shantanu Narayen

The other thing I would say is while we are focusing a lot on Flex builder, I think it’s important to remember that what we can really provide our customers is great workflow between our Creative applications and our developer applications. And even in Creative Suite 3, we’ve enhanced quite a bit the ability to go from the Creative applications into the developer applications. And so it’s that workflow that we believe will be a competitive advantage for us.

Steven Ashley - Robert W. Baird

Thank you.

Operator

We’ll go next to Eugene Munster, Piper Jaffray. Mr. Munster, your line is open. If you could pick up your handset or check your mute function.

Eugene Munster - Piper Jaffray

Can you hear me now?

Operator

Yes, please go ahead.

Eugene Munster - Piper Jaffray

Great. Good afternoon. Could you talk a little bit about average selling price? I think you might have mentioned it before but one of the powerful trends you’ve seen in past suites is by the suite approach, people have reached for bigger suites. This obviously is the mother of all suites, putting Macromedia and Adobe together. What kind of early feedback have you seen on the pricing?

Shantanu Narayen

I think the early feedback has been that people are adopting the suites. Clearly they recognize the value in those products, which is why we talked about the fact that thus far, we’ve seen quite a bit of revenue increase between what we had in CS2 and what we had in CS3.

At this point, it’s a little early to share exactly what that ASP increase might be over time.

Bruce Chizen

Part of the reason that the CS3 revenue or adoption is up 30% over, comparing apples with apples with CS2 is because of people going to the higher end suites. And it’s only the beginning -- keep in mind we haven’t shipped the uber-suite, which is the Master Collection, which is $2,500 in U.S. English.

I think you’ll continue to see as we offer value, people will probably buy the product that has that value in it and will be spending more money with us.

Eugene Munster - Piper Jaffray

I know you’ve said a dozen times on the call here don’t expect this kind of a progression, it’s still very early to try to predict this, but if you were going to say what inning are we in in this whole cycle, how would you respond to that?

Bruce Chizen

First batter up, we just hit a home run and we expect many more home runs to come.

Eugene Munster - Piper Jaffray

Okay, and lastly you talked about deferred revenue. One of the reasons you mentioned was that a deferral on CS2 to CS3 revenue, and I thought you mentioned that you had some other comment beyond that. Could you repeat what -- is that U.S. based, was it international based? Why was there some deferral of CS2 to CS3 revenue?

Mark S. Garrett

For the foreign language versions, because we weren’t shipping CS3, people that bought CS2 have the right to upgrade to CS3 and we defer that upgrade until we ship the CS3 foreign language versions and it gets reversed out in Q3, so we get the benefit of that revenue in Q3.

The second piece I mentioned was Lightroom. Lightroom was a product where we recognize revenue ratably because we provide updates to it and that ended up in deferred as well.

Eugene Munster - Piper Jaffray

One final question; you talked about inventory levels being in line with historical levels. That’s kind of surprising to me, given the fact that you’ve had to deal with just a massive headache of trying to manage this channel through this huge cycle. Can you give any other details in terms of what “in line” means?

Mark S. Garrett

It just means in line with our historical policy. We don’t disclose what’s out in the channel but in terms of what we take to revenue, we have a very strict policy about what is allowed to sit in the channel, so we reserve back for that.

Bruce Chizen

And that amount of inventory gets reviewed by both our audit committee as well as our external auditors, to make sure that we’re complying.

Eugene Munster - Piper Jaffray

Thank you.

Operator

We’ll go next to Trip Chowdhry with Global Equity Research.

Trip Chowdhry - Global Equity Research

Thank you and very good execution. I have two quick questions, the first is regarding the pricing in Europe. Is it true that you’re pricing your products in Europe almost twice what you are pricing in the U.S.? Has that always been the trend?

Shantanu Narayen

We look at pricing in Europe based on what the cost is for doing business in Europe. It is true that the price in Europe is higher than the price in the U.S. but it is not necessarily the numbers that you mention. We just continue to look at the feedback from our customers.

Bruce Chizen

And it’s similar to the pricing differential that we’ve used in the past, so the practice hasn’t changed significantly. Clearly we are also impacted by the relatively weak dollar in those countries that don’t do business in dollars.

Trip Chowdhry - Global Equity Research

The second question I have is on packaging. It seems like three base approach versus a customized bundle approach could have pros and cons, because some feedback that we are getting from your customers are they would like to have the flexibility to choose their own products, bundle them together and pay you X dollars. The push-back we are getting from your customers are telling us that they don’t like all the pieces in the bundle, they need only say 60%, 70% of the pieces and they would love to have the flexibility to create their own bundles.

Is there a technology limitation that is preventing you from doing that? Because my research is showing that if you enable to do customized bundles, you could do a lot better.

Bruce Chizen

No, it’s certainly not a technology limitation. The question is how much flexibility are we able to provide our customer and at what cost? Clearly our current strategy of offering six different suites, 13 different individual applications, as well as a master collection seems to be working based on the revenue that we produced this quarter.

Trip Chowdhry - Global Equity Research

Excellent. Congratulations on a very good execution.

Operator

We’ll go next to Chris Rowen with Soleil Securities.

Christopher Rowen - Soleil Securities

Most of my questions have been answered. Just on the Other revenue, do you expect that to continue to scale down or do you think it’s plateau-ing here?

Mark S. Garrett

For each of the business units, Creative, like we said, would be up significantly; Enterprise we think will be up slightly in the next quarter; and the remainder of them, including Other, would be down in Q3 primarily due to seasonality.

Bruce Chizen

Right, and Mark is referring to Q3. Again, we’re not providing any forecast beyond that. Keep in mind there’s a number of products or applications within that Other revenue that we could potentially see fueling future growth, including in the area of technical publishing with Framemaker, including in the area of e-learning with products like Captivate and a postscript raster image processing technology that continues to show lots of life, even though it’s approximately 25 years old.

Christopher Rowen - Soleil Securities

Okay, helpful. Thanks.

Mike Saviage

Operator, we’re running close to our stop time, so we’ll take two more questions, please.

Operator

We’ll go next to Daniel Cummins with Bank of America.

Daniel Cummins - Bank of America

Thanks, a couple of questions. Bruce, you’ve said before that creative professionals from your point of view don’t tend to be price sensitive in a good economy. Can you tell us whether, based on your most recent data, whether you’re operating in a good economy?

And then secondly, the break with the very specific or fairly specific fiscal year guidance to a more vague pronouncement of just coming in above, can you just tell us what triggered that change? Is there anything specific you can point to?

Bruce Chizen

Regarding the first question in terms of the economy, I am clearly not an economist. All I know is that people are spending a lot of their very precious dollars we believe this quarter, Yen, Euros, and other currency to buy great products to help them design, develop really cool websites, cool mobile content, great advertising, great ad brochures, great videos and more.

We believe the overall environment is relatively stable and companies continue to market their products and services. They continue to want productivity enhancements, which we believe helps fuel our Acrobat business as well as our Lifecycle business. So our conclusion is the economy is doing just fine but take it from a non-economist.

Mark S. Garrett

And then in terms of the guidance, as Bruce said, if our momentum continues, we would expect to exceed our annual guidance. The reason we said that we’d expect to exceed it and not give you a specific number is it depends on how Q3 comes out relative to our range. With Q3, you can do the math. If Q3 is at the low-end of our range, then we’ll be close to our guidance. If Q3 is at the high-end of our range --

Daniel Cummins - Bank of America

I think we all know how to do that math, but have you made the decision previously that you would never guide specifically above 15%? I’m just curious. It’s just strange that, and we’re not just talking about revenue -- we’re talking about profitability.

Bruce Chizen

Historically, we have never in the Q2 to Q3 timeframe adjusted our fiscal year guidance, and that’s because Q3 has seasonality associated with it and added to this Q3 will be the level of adoption that our customers will have with our new creative products. So for us to provide you with guidance for Q4 would mean that we would know pretty specifically what Q3 is going to look like. Quite frankly, that would be difficult for us to know until we get through the quarter.

Clearly if we came in at the high-end in Q3, Q4 is going to be that much better. If we come in at the low-end, Q4 will still be better than Q3 but not to as large a degree as if it’s the previous scenario. And obviously --

Daniel Cummins - Bank of America

Okay, so it sounds like there’s a precedent for it. That’s fine.

Bruce Chizen

Yes.

Operator

We’ll go next to Robert Breza with RBC Capital Markets.

Robert Breza - RBC Capital Markets

Good afternoon -- in before the end of the wire. My question really relates to the operating margins, guiding up to 39% operating margins. At the analyst day, you talked about upside, being able to drop down to the bottom line and manage more expenses appropriately. I guess my question is how are you thinking about the operating margins? Do you think 39% is sustainable as we move forward? Any kind of color you could provide on the operating margin side, that would be great. Thanks.

Mark S. Garrett

Like we said, 37%, 38% was our target but we also said that in quarters where we exceeded on the revenue line, we can’t prudently spend that money and some of it would drop to the bottom line and that’s what you saw this quarter. So operating margins ended up at 39% and we’re going to have quarters where that happens but we still believe that our margin target at 37%, 38% --

Bruce Chizen

And I’ll remind you that when Microsoft was around $10 billion, their operating margin percentage was around 35%. I will also remind you that Google’s revenue, even I believe today of around $10 billion, $12 billion, they are sitting with an operating margin percentage, at least recently, at 33%. So we’re very proud of our 37% to 38%. We’re very proud that we’re able to deliver 39% operating margin profit this quarter and not spend the money unwisely. We’re very proud of the fact that we’re delivering what we believe to be is great profit to our shareholders.

Robert Breza - RBC Capital Markets

Great. Nice quarter, guys.

Mike Saviage

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

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